Should I Dollar Cost Average?

NOTE:  This post is part of an ongoing education series.  This information is for educational purposes only.  This information does not constitute investment advice.  No rational person would make investment decisions based on a blog post.  Please consult with your financial advisor before taking any action.  If you do need help with your investments please contact us.

Definition from Investopedia.

The technique of buying a fixed dollar amount of a particular investment on a regular schedule, regardless of the share price. More shares are purchased when prices are low, and fewer shares are bought when prices are high.

Should you use the technique of Dollar Cost Averaging (DCA) when investing money?  With almost everything in investing - it depends.  As a general rule this method will reduce the risk (volatility) of your new investment but, it may also reduce your gain.  We will take an example of a person that has $10,000 to invest.

Usually, DCA is done over a few months but I will do it over 10 years to more clearly show the positive potential of this method of investing.  I will compare the results from two different strategies:

1) Lump Sum - you invest all $10,000 in the S&P 500 index on Jan 1, 2001 and do nothing for 10 years.

2) Dollar Cost Average (DCA) over 10 years.  Each year you invest $1,000 in the S&P 500 index on Jan 1 and the rest of the money sits as cash and earns no money.

To keep things simple we will ignore all fees and taxes.  Below are the returns for 2001 and the next nine years (a total of 10 years).

Year	Return
2001	-11.98%
2002	-22.27%
2003	28.72%
2004	10.82%
2005	4.79%
2006	15.74%
2007	5.46%
2008	-37.22%
2009	27.11%
2010	14.32%

Here are the results (2001-2010) of our two different strategies (Lums Sum is all in on day one and DCA invests $1000 per year and keeps the rest in cash)....

Year End	Lump Sum	DCA Invested	Cash	DCA Total
2001	$8,802	$880	$9,000	$9,880
2002	$6,842	$1,461	$8,000	$9,461
2003	$8,807	$3,168	$7,000	$10,168
2004	$9,760	$4,619	$6,000	$10,619
2005	$10,227	$5,889	$5,000	$10,889
2006	$11,837	$7,973	$4,000	$11,973
2007	$12,483	$9,463	$3,000	$12,463
2008	$7,837	$6,569	$2,000	$8,569
2009	$9,962	$9,620	$1,000	$10,620
2010	$11,388	$12,141	$0	$12,141

It can be very hard so see things in data - So I made a graph....

At the end of 10 years you have more money when you used the DCA method $12,141 vs $11,388 and the green line show less risk (volatility) then the red line.  So in this case you have less risk and more money.  This is the power of DCA.  While you will almost always have less risk using DCA, you will not always end up with more money.  The last 10 years are a great example for DCA because the first couple of years were large losses.  However, it does not always work out this way.  Let us look at another 10 year period.  Here are the returns by year 1991-2000.

Year	Return
1991	30.95%
1992	7.60%
1993	10.17%
1994	1.19%
1995	38.02%
1996	23.06%
1997	33.67%
1998	28.73%
1999	21.11%
2000	-9.11%

All but the last year are up years.  Here are the results (1991-2000)....

Year End	Lump Sum	DCA Invested	Cash	DCA Total
1991	$13,095	$1,310	$9,000	$10,310
1992	$14,090	$2,485	$8,000	$10,485
1993	$15,523	$3,839	$7,000	$10,839
1994	$15,708	$4,897	$6,000	$10,897
1995	$21,680	$8,139	$5,000	$13,139
1996	$26,679	$11,247	$4,000	$15,247
1997	$35,662	$16,370	$3,000	$19,370
1998	$45,908	$22,360	$2,000	$24,360
1999	$55,600	$28,292	$1,000	$29,292
2000	$50,534	$26,623	$0	$26,623

... and the graph...

Again we see that the DCA method resulted in less risk (smother line).  However, in reference to total returns you would have done much, much better just putting the money in all at once $50,534 vs $26,623.

The problem with investing is that you never know in advance if the market is going to go up or down.  A financial advisor may be able to help you explore your options and decide which method is best for you given your situation.  I know it's tricky and I hope that this helped.  If you have question you may put them in the comments or ask me off line.

Should I Use A Fee-Only Advisor?

NOTE: This post is part of an ongoing education series. This information is for educational purposes only. This information does not constitute investment advice. Please consult with your financial advisor before taking any action. For planning advice contact Polaris Financial Planning. It can be argued that the best way to invest is to do all of the work yourself, for some people this is true. If you are really interested the subject and willing to spend the time needed you will likely do well.

However, most people are busy and there are other demand on their time. Often jobs, kids or other project keep them occupied. If you aren't careful with your investments you can make big mistakes. In a busy life, we often use experts to help us. Instead of learning all of the legal details, you can hire an attorney to create a will. Instead or working on your own car you can hire a mechanic. You can do these things if you spend the time needed to acquire the skills or, you can hire an expert and have more time to do the things you want to do. I see investing the same way.

When you are looking for a financial advisor you need to know, there are two types:

1) Commission

and

2) Fee-Only!

Most advisors collect a commission to sell product to you! However, a small percentage collect a fee from you these are Fee-Only advisors and they are paid by you. Therefore, they work for you. They focus is on getting the best results for their clients, not selling more stuff to make more commissions.

I think About.com summed it up really well....

A fee-only financial advisor cannot receive compensation from a brokerage firm, a mutual fund company, an insurance company, or from any other source than you. This means they represent you and your interests when giving you advice. After all, think about where someone's paycheck comes from, and that will tell you quite a bit about where their loyalty lies.

When selecting an advisor you should ask these two questions:

1) "How are you paid?"

2) "Where do you invest your money?"

An advisor that is paid by commission may have to make choices based on how much commission is paid by a specific investment product. Some complex insurance product may pay an advisor 10-15% commission and a managed mutual fund may pay up to 8.5% commission. Do they want to make 3% or 15% helping you "invest" the $100,000. What would you do? There is the temptation for a commission advisor to put your money in a product that pays the higher commission so they can make more money. They may be able to resist this temptation - but how will you know?

As I have discussed before, one of the single best things to use for investing is low-cost index funds. However, these funds do NOT pay a commission. A commission based advisor would have to choose between getting paid or getting you the best product. I suggest you avoid being put into this situation and get a Fee-Only Advisor!

How Does Turnover Ratio Affect My Mutual Fund Return?

NOTE:  This post is part of an ongoing education series.  This information is for educational purposes only.  This information does not constitute investment advice.  No rational person would make investment decisions based on a blog post.  Please consult with your financial advisor before taking any action.  First we get the definition of turnover from Investopedia...

The percentage of a mutual fund or other investment vehicle's holdings that have been "turned over" or replaced with other holdings in a given year.

In a mutual fund you pay your share of all trading costs.  The more trades (turnover) the higher that expense is.  According to the Wall Street Journal...

A study updated last year of thousands of U.S.-stock funds put the average trading costs at 1.44% of total assets...

Let's try an example to make the costs clear.  If you have $10,000 in a mutual fund that makes a return of $1,000 or 10%, you would pay on average 1.44% of the $10,000 for the trading costs.  You would not actually make the $1,000 (10%) you would only make $856 or 8.56% (10% - 1.44%).  Keep in mind that the trading cost are NOT part of the mutual fund expense ratio (average around 1.5%) that must be reported by law.  It is very hard to figure out how much a given fund spends on trades.  One thing you can count on - It's not for free and all of these expenses are paid for by you.

According to a report by Morningstar....

William Harding, an analyst with Morningstar, says the average turnover ratio for managed domestic stock funds is 130 percent.

Let's take a look at an ultra low cost index fund.  It has a turnover ratio of about 4-5%.  If the trading cost for 130% turnover is 1.44% of your return then we can estimate that a turnover of 4-5% will cost about 0.05% of your return.  So, on your $10,000 investment you can pay $144 in trading costs or $5!

The other problem with turnover is taxes.  If your fund has a high turnover (over 100%) then almost all of the money you make will be taxed at your income rate.  This can be as high as 35%.  However, if the stocks are owned for more than a year then you would only pay capital gains rate of 15% (or less). 

This is a lot of math but let's bring it all together with our $10,000 investment example above:

In an average turnover, average expense fund you could make $1000 less an expense ratio of 1.5% less trading costs of 1.44% (net $706) and could pay 35% in taxes.  You only keep $491 ($706 - 35% in taxes).

In an ultra low cost, low turnover index fund you could make $1000 less an expense ratio of 0.2% less trading costs of 0.05% (net $975) and then pay just 15% in taxes.  You keep $829 ($975 - 15% in taxes).

How much do you want to make $491 or $829?

Why Low Investment Costs Matter

NOTE:  This post is part of an ongoing education series.  This information is for educational purposes only.  This information does not constitute investment advice.  No rational person would make investment decisions based on a blog post.  Please consult with your financial advisor before taking any action.  Before I show you why low investment costs are so important let us define the expense ratio of a mutual fund.

Depending on the type of fund, operating expenses vary widely. The largest component of operating expenses is the fee paid to a fund's investment manager/advisor. Other costs include recordkeeping, custodial services, taxes, legal expenses, and accounting and auditing fees. Some funds have a marketing cost referred to as a 12b-1 fee, which would also be included in operating expenses. A fund's trading activity, the buying and selling of portfolio securities, is not included in the calculation of the expense ratio.

In simple terms lets say you invest $100 in stock mutual fund.  If it goes up 10% and has an expense ratio of 1.6% you make $8.4 not $10.  If the expense ratio was just 0.2% you would make $9.8.  Keep in mind that this does not take into account the costs of buying or selling or the higher taxes that you may pay in an active fund.  I will talk more about those in future posts.

The extra $1.40 sure is nice but lets take a look at the effect over time.  We will start with $10,000 and assume a 10% return per year for the next 30 years.  One fund returns a net of 8.4% per year and the other returns 9.8% per year.  After 30 years would would have either $165,223 or $112,429.  A difference of almost $53,000!

What Is The Difference Between A Load Fund And A No-Load Fund

NOTE:  This post is part of an ongoing education series.  This information is for educational purposes only.  This information does not constitute investment advice.  No rational person would make investment decisions based on a blog post.  Please consult with your financial advisor before taking any action.  A load fund charges you a fee or commission.  This fee can 3%, 5% or as high as 8.5%.  A no-load fund does not charge this fee.  If you invest $10,000 in a no-load fund it is worth $10,000 the day you bought it.  With a load fund you actually invest less.  If you buy a fund with a 6% load you may start with $10,000 but 6% or $600 is taken as a fee/load/commission.  You actually invest $9,400.  Usually, the $600 goes to the broker or advisor that sold you the fund.

There is nothing wrong for getting paid a commission for selling something, people do it all of the time.  The problem is not with the sales person but with the system.  There is a temptation for the sales person to sell a product with a 8% load instead of a 5% load.  Would you rather make $500 or $800.  What would you do?

One thing skeptics know is that humans can be very good at justifying their choices.  The mind of a sales person can do amazing things to fix the cognitive dissonance that may exist.  Did they sell a product that was good for you or good for them?  Odds are that the product with the higher load may not be as good - but how will you know?

This is why you should find an advisor that is paid buy you.  An advisor that is "Fee-Only".  "Fee-Only" means that the only money they get is the fee that you pay them.  People work for the person that pays them.