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Wednesday, February 17, 2016

Combining Momentum and Dollar Cost Averaging for Smoother Results

Josh Brown (i.e. The Reformed Broker) recently shared the aptly titled post How to Make Volatility Your Bitch highlighting how dollar cost averaging into a volatile market can lead to higher overall returns:

Door number one – you spend 15 years putting $1000 into an investment every month for 15 years, with the possibility of seeing that investment get cut in half twice.
Door number two – you spend 15 years putting $1000 into an investment every month for 15 years, with the same annual performance of what’s behind door number one, but no drawdowns.
Which would you choose? 
On the surface, you’d choose door number two. Of course, who wouldn’t? 
But it’s the wrong choice. The trick here is to remember that you’re adding to the investment at a rate of $1000 per month. That’s when you realize that door number one, with it’s twin 50% crashes, is the better option.
His point is an important one for long-term investors... you would rather pay less (than more) for a security today if it is worth more in the future and for long investment horizons that has typically been true. So in general, regularly contributing to your retirement (or other long-term goals) is good practice.

The Caveat

BUT there is a caveat... dollar weighted returns are only better than time weighted returns if the dollar weighted price you paid was lower than the price at the ending date. As dailyVest outlines (bold mine):
In contrast with a time-weighted approach, the dollar-weighted rate of return calculation method does measure the size and timing of cash flows, as well as the investment performance. Thus,
  1. Periods in which more monies are invested contribute more heavily to the overall return – hence the term “dollar-weighted” 
  2. In this case, investors are rewarded more for larger investments made during periods of greater price appreciation 
Given we are so close to the all-time high in the S&P 500, chances are each dollar invested over the last 15 years was below (or well below) the current price, resulting in more investments having greater price appreciation and dollar weighted returns > time weighted returns. So... rather than looking at just the current 15 year period, let's go back and look at 15 year periods ending 5 and 10 years back (which end at less of a peak) to see how well the same door number one vs door number two worked out.

Note: the analysis below shows $1000 invested each month in the S&P 500 and in a return stream with identical 15 year time weighted returns, but with 0% volatility.

Dollar weighted returns > Time Weighted Returns over Most Recent 15 Years

Dollar weighted returns < Time Weighted Returns over 15 Years Ending 2010

Dollar weighted returns < Time Weighted Returns over 15 Years Ending 2005

In these examples we see just how important the ending point is in determining which return stream "wins", as well as how important the end date is in the overall growth of the $180,000 contributed (which is a reason why investors generally should derisk as they approach retirement). It also outlines why dollar cost averaging into a solution that can protect against the downside may be beneficial relative to a buy and hold strategy by limiting the amount of dollar weighted contributions made at poor entry points.

Dollar Cost Averaging in a Capital Preservation Strategy: The Case for Momentum

Because I have the urge to compare all buy and hold strategies with momentum, the below replicates the above charts and adds a momentum equity curve with this simple rule at month-end:
  • If S&P 500 > 10-Month Moving Average, then S&P 500
  • Otherwise, Aggregate Bonds
Similar to what is shown in the charts above, the charts below outline the growth of $1000 a month into the S&P 500, an identical time weighted return series with zero volatility, and the above momentum strategy.

The momentum strategy provided much more consistent dollar growth in all three time frames and in these specific windows materially outperformed both a buy and hold and 0% volatility iteration (this will not necessarily be the case in all periods - especially in up and to the right equity markets). So... perhaps it's the combination of consistent contributions and a strategy more focused on capital preservation that can more easily make volatility your bitch (without the volatility).