How to reduce risk and even improve return for investing in a stock.

In the previous article we discussed how contributing to an DCA (Dollar Cost Averaging) can yield diminishing returns, as much of the costs are determined by the buying prices at the time of investment. It showed how the benefits of dollar-cost averaging disappear over time, and that the start time of investment is an important factor affecting your return.

DCAs emphasize buying fewer units as price increases and buying more units as price decreases. With the accumulation of more units comes diminishing benefits. This can be attributed to the scheduled buying of units, which are purchased regardless of the stock price at the time.

How might the power of reducing cost in an DCA be affected by a “buy low, sell high” investment strategy? Imagine we have two separate asset pools, one is invested into a stock and the other into a cash equivalent account. Then imagine the percentage market value of the stock is fixed and unaffected by price. To maintain the stock percentage, we buy or sell the stock every year to balance its portion with that of the cash equivalent account. This investment strategy is referred to as Fixed Allocation Percentage (FAP).

In contrast with an DCA, how does an FAP affect investment return in a stock? Let’s see in the example below. For our FAP strategy, we invest in the U.S. stock market and in a cash equivalent account represented by SPDR S&P 500 ETF (SPY) and SPDR Bloomberg Barclays 1-3 Month T-bill ETF (BIL). We keep our percentages of market value for the SPY and BIL at 70% and 30%, respectively. We do this for both stocks as we intend to sell one stock in order to buy another stock once a year.

 

Comparison of averaging cost when investing 10,000 per month

What are the results of reducing cost and investment return between the DCA and the FAP? Looking at Fig. 1 it becomes clear that the effects of averaging cost of the FAP and the DCA are nearly identical if we invest the same amounts using both strategies every month. Regardless of plan, most people tend to invest a large amount initially followed by more fixed or variable amounts in the latter periods. We’ve developed an equation to easily indicate which strategy (FAP or DCA) works best when reducing cost, called the Ratio of Compared Average Cost (RCAC) for both strategies. It works as follows: subtract the average cost of DCA by the average cost of FAP, then divide this by the average cost of DCA. If the effect of reducing cost for FAP is better than that of DCA, RCAC is negative. Otherwise, RCAC is positive.

 

Investing variable amounts in the first month followed by a fixed amount of 10,000 in the following months

Average Cost Effect under different initial investment Amount

In Fig. 2 you can see that FAP can actually reduce cost compared with DCA. The greater the difference of a monthly investment, the more beneficial it becomes to reduce the cost of an FAP compared with an DCA. Compared with an DCA that only buys shares, an FAP would buy or sell shares to maintain a fixed percentage, which enables reducing cost in FAP to surpass that of an DCA.

 

Investing in markets with deviating past performance

In the previous examples, we’ve only looked at the U.S. market to compare the power of reducing cost between FAP and DCA. So to better illustrate the overall effect reducing cost, we chose five markets based on their accumulated return over a fifteen year period, from June 2004 to May 2019, and compared their performance in the figure below. The worst performing market is Italy, whose accumulated return is nearly zero over this span. The best performing market is the U.S. with an accumulated return of 231.78%.

For example, say we invest 1,000,000 in the initial month and 10,000 in the following months for fifteen years in these markets. The chart below compares the power of reducing cost of FAP and DCA in diviating markets based on this investment.

Average cost effects under different performance of markets

Figure 3 shows that despite the performance of any given market, FAP shows more power to reduce cost (negative RCACs in every period) compared with DCA.

Looking at the accumulated return in deviating markets when comparing FAP with DCA

FAP actually has more power of reducing cost and risk over DCA. But which strategy yields greater returns across different markets? Well, let’s say we also invest 1,000,000 in the initial month and 10,000 in the following months from the best performing market, the U.S., to the worst performing market, Italy, to compare the accumulated return when using three distinct investing strategies.

Notice that DCA only outperforms FAP in the stable and upward U.S. market, due to investing all assets in one stock. In all other cases, FAP outperforms DCA. This is due to the typical up and down price variation seen in most stock markets around the world. This natural behavior causes the buying and selling of shares in an FAP and accelerates the process of reducing cost.

The more you take advantage of reducing cost, the lower your average cost will be, which results in lower risk and higher return. Considering the analysis we’ve laid out, here are our three conclusions when comparing FAP with DCA:

  • The greater the difference of investment amount across different time periods, the more significant an effect dollar-cost averaging has on FAP over DCA
  • Regardless of market behavior, the power of averaging cost of FAP is better than DCA.
  • Excluding stable upward markets, FAP shows better performance than DCA.

 

 

In stable and upward markets, FAP allocates some assets in cash equivalent accounts with lower risk and return compared with an DCA that allocates all assets in a stock market trending upward that reflects the lower return of FAP. If FAP allocates assets in a stock and a cash equivalent account, does it perform better? An asset allocation strategy makes for the best choice.

 

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