July Market Update by Jack MollerSubmitted by Moller Financial Services on August 2nd, 2016
Markets’ Post-Brexit Rally Continues
It reminds me of the famous quote attributed to Mark Twain: “Reports of my death have been greatly exaggerated.” Once again all the dire predictions of imminent disaster after the British voted to leave the European Union have not come to pass. While time will tell what the impact is of the exit on the United Kingdom, on Europe, and possibly on the United States, we do know that our markets have finally broken out to new all time highs after swinging wildly for over a year. In fact, many of the other beaten up markets around the world have recovered somewhat as well. Once again, we see that making any investment decisions based on an assessment of the “news of the day” doesn’t work. It is critical to maintain adherence to our strategies.
Beautiful Math of Dollar Cost Averaging
In this commentary, I wanted to add some thoughts on the importance of limiting volatility for those people in or near retirement.
Math Works Automatically for Disciplined Saver
For years we have extolled the benefits of dollar cost averaging (DCA) for savers accumulating assets to fund future financial goals. DCA is essentially investing a fixed amount on a regular basis as many of us do in 401(k)’s or through automatic investment plans.
The net is that you end up with a lower average cost than the average price for the period. I’ll use a simple example:
- Automatic monthly savings of $100 per month to purchase Fund A
- Monthly price examples and purchase amounts
- 1st Month price $10, so the $100 purchases 10 shares
- 2nd Month price $20, so the $100 purchases 5 shares
- 3rd Month price $5, so the $100 purchases 20 shares
- 4th Month price back to $10, so the $100 again purchases 10 shares
- After these four months, the investor has invested $400 in purchasing 45 shares
- Average cost per share = $8.89
- Average price during period = $10
- Investor has a profit of $50 even though price is back where it started!
I would like to highlight a few salient points:
- The discipline of the strategy forces investors to automatically be cautious at high prices as they purchase less shares and aggressive at low prices as they purchase more shares.
- The saver benefits with high volatility!
- We typically recommend, instead of purchasing a single fund, that the investor buys a basket of investments. In this way, it is essentially value averaging by purchasing more of whatever is most underweighted usually at cheaper prices. This approach further increases our aggressiveness at low prices and caution at high prices.
Oops – Math Flips and is Disadvantageous in Distribution Phase (e.g. retirement)
Unfortunately the math doesn’t work so well when beginning to tap into one’s portfolio. For example, many people in retirement would like to continue to “receive a paycheck” by taking monthly fixed distributions from their portfolios. Unfortunately, the math reverses and to distribute a fixed dollar amount each month, we are forced to sell more shares at lower prices and less at higher prices.
Again, I have a couple of comments/observations:
- This negative math is lessened somewhat by holding and taking distributions from a diversified basket of investments. With the basket, we end up selling more of whatever has done relatively better (higher prices) and less of whatever has done poorly (lower prices). Nonetheless, if our overall portfolios are volatile, we can end up having to sell aggressively despite lower prices worsening the impact of the decline.
- Thus, limiting volatility in portfolios in distribution can greatly benefit the retiree. In this sense, we develop portfolios and strategies that seek less volatility to aid in retirement and extend the life of a portfolio.
Volatility is a double edged sword and should not automatically be feared. In fact, we do know that generally the investments that are likely to generate the best returns over the years tend to be those with the highest volatility – e.g. the highly volatile small companies have historically achieved some of the best returns which is in stark contrast to money market funds which have no volatility and minimal returns. Nonetheless, taking steps to reduce volatility in retirement definitely makes sense and can be quite beneficial.