Category Archives: Indexing

Dollar Cost Averaging

With the “New Normal” looking like it means that it is commonplace for the markets to move plus or minus 2% in a single day of trading, it can be understood if an investor asks him or herself about when money should be put to work.

I would advocate for almost always.

Dollar Cost Averaging is a simple average. If you continuously buy a certain security over a period of time at different prices, the average cost is what you base your profit or loss upon. It is basically putting your portfolio on auto-pilot, which can remove some of the emotions of investing, and letting your investment build over time, which removes the stress of trying to decide when to buy.

To illustrate the point I created two simple portfolios. I randomly selected a low-cost Canadian index fund, and selected January 2007 as the starting date of the portfolio, which gives us three and a half years of data.

The assumption is that two investors had $5000 to invest at that time. Investor A put all $5000 in the Canadian Index fund; Investor B put $900 in to start, put the remaining $4100 in a high interest savings account, and set up an automatic withdrawal to invest $100 per month from that account.

After 3 and a half years where are our investors?

Investor A is currently just above par with a gain of 0.9%, which is only because of re-invested distributions, which were paid annually.

This investor probably would have encountered a good amount of stress as he watched his holding drop 50%, from a high of over $6000 to just above $3000.

And Investor B?

By investing $900 to start, and $100 every month, this investor would also have invested a total of $5000, but she would be over 5% ahead because of dollar cost averaging, reinvested distributions, and interest.

This is because she would have been buying small amounts of the fund through good times and bad, smoothing out the average purchase price.

She would also have been receiving interest on the cash she had in the high interest savings account, which was slowly being depleted over the three and a half years.

I suspect Investor A would also have had less stress to deal with through the recession, as her portfolio would have been down about 20% at the trough (the invested capital would have been down 30% – from $3000 to $2000 – but she would have had about $2000 sitting in cash).

I’ve written before about the investing lessons learned from Aesop. He brings us wisdom again today in the form of slow and steady wins the race.

There will be times when it may seem like indexing and dollar cost averaging is a losers game (at one point, Investor A had over $6000 to Investor B’s $5500, for example), but I am confident that over the long-term it is the way to smoothing fluctuations, lowering stress, and increasing your net worth.

A Simple Plan

I use RBC’s Direct Investing as my brokerage and have my portfolio set up to reinvest dividends. I’ve used and enjoyed this system for years, but TFSAs have me thinking about new strategies for the future.

What popped into my mind today is the possibility of using dividends as contributions to (and in turn investments within) a TFSA. This would also work as an RRSP strategy, but I’ll get into why I think TFSAs are perfect for this in a moment.

The idea goes as follows:  First you would turn off the automatic dividend reinvestment option (if it is enabled) so any dividends received would be deposited into your cash account. You would then transfer the cash into your TFSA. Just to keep things simple, and easy to track total deposits to the TFSA, you may consider using multiples of $5 (ie. a dividend of $26.25 would mean $25 into the TFSA, with the remainder sitting in cash until the next dividend).

As to why I think a TFSA is the better choice, it is because they are funded with your after-tax dollars. If you want to make a $1000 deposit, and you are in the 30% tax bracket, you would have had to earn about $1400 first. Since eligible dividends from Canadian companies are taxed at a lower rate, it seems to me that by using dividends to partially fund a TFSA, you would lower your effective tax rate at which TFSA investments would be made/calculated.

This is actually an adaptation of a plan I had some time ago, which in itself was based on Buffet: I had thought about using dividends in order to buy index funds in the same way Buffet takes the earnings and dividends from one company in order to invest in or buy other companies. Once the cash is in your TFSA, you could do like above and buy index fund units, or another strategy would be to save up for an equity purchase.

By using dividends from Canadian companies you get a tax advantage. Once you had a decent amount of cash stocked up, you could then buy a quality U.S. stock. You would have achieved a lower effective tax at which you bought the U.S. share, and then the only tax payable would be the 15% withholding tax on U.S. dividends.  Any capital gains would be tax-free (of course, any capital losses would be ineligible for use as a tax write-off).

Some more number crunching would be necessary to really come up with the pros and cons, but for now this seed of a strategy seems like it could blossom.

Survivorship of Actively Managed Funds

A blog I read on relatively daily basis is that of the Canadian Capitalist (link in the sidebar). The main reason is that his ideas, temperament, strategies and goals are somewhat similar to mine. The second reason is that by being one of the most frequented Canadian finance blogs, he brings in an informed readership that offers a wealth of information, opinions and dialogue.

One of the comments on his March 1st post  had a link to an interesting report from S&P that discusses index vs. actively managed funds and their returns.  There are several aspects of this report that interest me, but the thing that stands out the most is the commentary/data on survivorship bias correction.

A slight digression: Advocates of actively managed mutual funds (or the pamphlets of the companies that sell them) often quote data that suggests that those funds are better than index investing.

The truth is that this data often does not include information regarding funds that have ceased to be.

I first became aware of this when I read The Intelligent Investor by Benjamin Graham with commentary by Jason Zweig back in 2007. Zweig shows data in the commentary to chapter 9 (p. 248) regarding how many funds outperform the index, and in the footnotes, points out that the data does not account for all the funds that are no longer in existence.

The S&P report, however, takes this into consideration and reports the numbers as they are. In other words, the percentage that the S&P report presents gives the percentage of the funds that existed at the end of 2009, with the base being all the funds that existed a certain number of years ago.

An an example using data from the report:  there were 153 U.S. equity funds 5 years ago. At the end of 2009 there were only 73 (in other words, 80 funds have disappeared, either because they failed so miserably and have liquidated… fund lingo for “folded”… or because they merged into other funds). Of the remaining 73 that were still in existence, only 14 had outperformed the U.S. index over the 5 year period.

A fund company may state the following: 20% of managed funds out-perform the index over 5 years (because 14 out of 73 is 20%)

This is like saying 50% of baseball teams win the World Series because there are 2 teams in the series, and 1 wins.

In reality however, only 9% of the funds managed the feat of out-performing the index because an investor 5 years ago had the option of 153 funds… not 73. Put another way, and investor 5 years ago who put his/her money into an actively managed U.S. Equity fund  had a 91% chance of underperforming the index.

And this is the value of the S&P report on Canadian funds, as it takes this into consideration, and reports the numbers as they should be reported.

Back to the baseball example for a moment, there were many teams that did not make the play-offs, and others that were eliminated in the round-robin. In any given year, only 1 team out of 30 can win the World Series. [the odds increase to 1 out of 29 if you accept that Toronto is a non-factor 😉 ]

Any bookie understands this. The odds they give on any given team to win the World Series on day one of the season will vary greatly from the odds they give the same team when they are up 3 games to nil on the eve of game four.

Remember that when you pick your next fund.