Wednesday, June 18, 1997
Fribble III on
Dollar-Cost Averaging
-Or-
Does the Psychic Network Have A DRiP Program?
by
TMF Runkle
In two earlier Fribbles (1&2) I've looked at Dollar-Cost Averaging, and analyzed how well it performed compared to investing an equivalent lump sum all at once. I used the Dow 30 stocks and tested the model over three and ten years. I did not reinvest dividends. That admittedly skews the results because the stocks that perform poorly in price appreciation often have a high yield. However, how do you annualize returns of quarterly dividends for monthly contributions? I couldn't think of a reasonable way to do it. Also, some companies have spun off, like Lucent and NCR from AT&T. How do you figure that in? It can be done, but I don't want to spend the rest of my life on this Fribble. Making the whole project tougher is the fact that they changed the Dow from what it was 10 years ago and 3 years ago. Do I use today's Dow or the ones back then? I used both. Perhaps I'll go more in depth in a research paper for my MBA studies at a later time.
My main interest was to see if the principle of Dollar-Cost Averaging (DCA) shares really was true. The idea is to put away a fixed amount on a regular basis; when the stock price goes down, you buy more shares. When it goes up, you buy fewer. I also wanted to compare different DCA strategies. This is of particular interest to those of us that invest in Dividend Reinvestment Plans (DRiPs), since we usually make monthly contributions and hope to benefit from Dollar-Cost Averaging.
Does this really work? On a three-year basis, the annualized returns were actually lower than if you invested that money all at once. Over ten years, however, you would have done better on an annualized basis by dollar-cost averaging. Some stocks did much better than others in both cases, though. How do you find them?
First, what makes the annualized returns perform well in DCA? I graphed some of the better performers, and found that you need a long period of stagnant stock price growth. So, if you are psychic, you should start your DRiP program now and pick a stock that your tea-leaves say will be flat for a while. It will pay you a lot better than answering the phone for a 900 number service. Since most of us aren't psychic, though, and probably have the 900 service blocked on our phones, what do we do?
To choose a model DCA portfolio, I tried the Beating the Dow approach to see how that would fare. I tested the Beating the Dow approach in both three years and ten. Guess what? It didn't work over ten years. Here are some numbers:
10 years
Dow DCA: 18.95 % (Today's Dow)
BTD4: 16.70 %(Using the Dow of 1987)
3 years
Dow DCA: 24.70 % (Today's Dow)
BTD4: 26.17 % (Using the Dow of 1994)
Why didn't it appear to work better than the market over ten years? AT&T was one of those stocks, and its share price hasn't done well in recent years. Without it you would have had a return of 21.59 %. And let me remind you that I didn't include dividends. AT&T has been paying a high yield for the past ten years, AND it spun off Lucent Technology and NCR. Factoring that in, you would have done quite well even with the Beating the Dow approach.
Let's try a different approach, what I call the Fundamental Approach. Let's look for companies that had 5-year previous growth in earnings, and the same in cash flow. Also, we'll look for ones with greater than 12 % growth in earnings for the next two years, and assume the analysts back then predicted such a rate. Why this criteria? A five-year period of earnings and cash flow growth shows the company is well established, and has a good record of increasing profitability. I used 12% as the benchmark for earnings growth because it exceeds the average for stock price growth in the market. I also used today's Dow to make things a little easier on myself. How are the results?
10 years: 20.21%
3 years: 28.74 %
The results for ten years would have been much better if you didn't buy Wal-Mart or McDonald's. Again, being psychic would have helped you. Without those two, you would have had a 25.68% return. However, remember this data is from March, when I began this series of Fribbles. I'm trying to keep some consistency in my results. Using today's stock prices, your results would be much better. Since I'm not psychic, I can't tell you for sure, but this might be one of those flat periods that will help you in the future with McDonald's in DCA investing. My horoscope doesn't say anything about it, and my Magic 8 Ball won't work anymore.
In the end, how do you guarantee good results on your DRiPs when you dollar-cost average? Save your money, and don't call the Psychic Network. To choose your initial portfolio, I would use either the Fundamental Approach or Beating the Dow. Don't get discouraged when the stock price is stagnant, or drops for some reason or other. That is a buying opportunity. If the company appears to be entering into a period of long-term problems with slowing earnings growth, drop the stock from your portfolio. Dollar-cost averaging is truly long-term investing, and requires careful selection of the companies you buy, and a discipline to follow through on the strategy. You don't even have to make up a Fiendish Spreadsheet or be friends with Serena the Sexy Psychic from Weekly World News to know that.