Interesting Trends in Fidelity 401(k) Data

The New York Times recently published an article discussing Fidelity 401(k) investment trends. Due to the recession, many investors have moved their retirement money into more conservative investments. Bonds and life cycle investments have become more popular. Life cycle investments reduce risk as the investor approaches retirement age.

Could Google Have Predicted the Recession?

Earlier this week I discovered Google Insights – a tool to see the statistics of historical search queries. For example, the following chart shows the frequency of the search term “recession”.

It’s obvious that searches related to recession spiked during this current financial crisis. Here’s the performance of the S&P500 during the same time period.

Just thought that was interesting.

Today’s Finance Reading

I Say Spend. You Say No. We’re in Love. (NY Times)

First up, an article in the NY Times regarding the tendancy for spendthrifts, who spend money wrecklessly, to marry tightwads.

America’s Most Important Problem: Economy vs. Health Care (NY Times)

A new Gallup poll suggests that more Americans are considering health care as the most important problem facing the US. 60% of respondants mentioned economic problems, 25% mentioned healthcare.

Starting Thursday, Credit Card Users Get More Rights (Washington Post)

The new credit card legislation will, among other things, force credit card companies to  (1) give 45 days notice before changing interest rates and (2) mail bills 21 days before the due date.

There Goes The Prize (Washington Post)

Credit card companies are changing their rewards programs to the benefit of the bank.

Will U.S. Recovery Go Global? (Washington Post)

Robert J. Samuelson argues that a US Recovery depends heavily on a global recovery and a global rebalancing – particularly between the massive Chinese exporting machine and spendthrift American consumer.

Dollar Cost Averaging over a Decade

As we all know, it’s been a fairly rough decade for the stock market. Dollar Cost Averaging (as introduced yesterday) is a common technique to purchase stocks. In the upcoming week, we will be doing an analysis of Dollar Cost Averaging to see how well it works or if it is just a load of BS.

To start off, let’s see how dollar cost averaging would have worked for the past ten years. We will assume that our imaginary investor, Jenny, invests $1000 each month into an index fund that tracks the S&P500 index. She starts this investment on August 16, 1999.

After dollar coast averaging for a decade, how much money does Jenny have today?

Today, Jenny has accumulated $103,491. But due to the rough times on Wall Street, Jenny would have done better just dumping her money in a low yielding savings account. During these 10 years, Jenny has gotten a return of -13.76%. This means she’s invested $120,000 but only has $103,491 to show for it. Her annualized return is (-1.47%).  Not so good.

How does Jenny’s performance compare with the index performance?

In August 1999, the S&P index had a price of 1330.77 (adjusted for dividends and splits). Today, the S&P index is at 1004.09. The annualized return for the index was (-2.78%). That is, if Jenny put the $120,000 into the market back in August 1999, she would currently only have $90,542. Yikes! Of course, most people save incrementally and don’t have a huge lump sum of money to invest.

Over the past decade, dollar cost averaging saved Jenny approximately $13,500 had she just invested the $120,000.

Ok so dollar cost averaging was good for the past decade. Is it always better for ten year periods?

To answer this question, I randomly chose 1,000 ten year periods between 1950 and 2009. I calculated the return of the index as well as the return from dollar cost averaging with $1000 invested monthly with no commissions.

First, the results from dollar cost averaging are shown in the plot below. This is a histogram showing all the results we saw from this random selection of ten year periods. Dollar cost averaging returns ranged from -50 to 180%. The average dollar cost averaging return was 51.5%, which corresponds to an annualized return of 4.24%.

Now let’s look at the return of the S&P500 index. This is the return you would receive if you invested one lump sum at the beginning of the ten year period. The average return of the index over these randomly sampled ten year periods is 124% corresponding to an annualized return of 8.41%

The Conclusion

Although dollar cost averaging seems to have limited the damage over the past ten years, this analysis suggests that dollar cost averaging will typically underperform the index where you are investing. Out of a 1000 randomly sampled ten year periods, the dollar cost averaging annualized return is only about half of the return of the S&P500 index (4.2% vs 8.4%).  What does this mean? It means that if you have a lump sum of money, this historical analysis suggests you should invest all of it at one time rather than gradually investing portions of the lump sum over ten years.

Studying Dollar Cost Averaging

If you are new to investing, Dollar Cost Averaging may mean absolutely nothing to you. If you regularly contribute to a 401(k) or IRA, you are most likely already dollar cost averaging. In layman’s terms, dollar cost averaging means you invest a specific amount of your savings at regular intervals such as every two weeks, every month, etc. Studies have shown that investing at regular intervals helps your investments make you more money.

How does Dollar Cost Averaging make you money? Think of THE fundamental law of investing: buy low, sell high. If you could know the future, you would buy your stocks when they are relatively cheap, hold on to them for a certain amount of time, and then sell them once those stocks are more expensive. Easy, right? Unfortunately, it’s very hard to predict what the price of the stock will be in the future. In fact, many people do exactly the opposite especially if they let their emotions drive their investment decisions. Dollar cost averaging is a systematic way to buy low, sell high – a way to say screw you, stupid emotions!

In dollar cost averaging, when stocks get cheaper, you buy more stocks. When stocks become more expensive, you buy less stocks. See! So dollar cost averaging forces you to buy more when stocks are cheap! Let’s use an example to demonstrate. Suppose Bob invests $1000 each month into his favorite stock, Coca Cola (KO).  In January, the stock price is  $20 so Bob gets 50 Coca Cola stocks. By August, Coke’s stock price goes up to $25 so Bob only gets 40 Coca Cola stocks. Dollar cost averaging forces Bob to always buy more stocks with they are cheaper.

In the upcoming posts, I want to dive into Dollar Cost Averaging even further using real world data. Some of the questions I want to answer include:

• How has Dollar Cost Averaging worked out in the past 5, 10, 20 years?
• How do commissions (if any) affect the performance of Dollar Cost Avaraging?
• Does the interval when you make your investments affect the performance of dollar cost averaging?
• If you have a large amount of money you want to invest, is it better to buy stocks all at once or use dollar cost averaging? (A university group has already studied this. Over the long term, it makes sense to go ahead and put all the money in at once. I want to verify this.)

I’ve written a program to download historical price data on a stock or index. As you can see below, I’ve also added a little group of controls to analyze different ways to Dollar Cost Averaging. I’ll probably be adding more as I start getting into the analysis.

If you want to learn more, check out the Wikipedia entry on Dollar Cost Averaging.