Dollar-Cost Averaging – The Easiest Way to Make $1 Million

by Teeka Tiwari | January 13, 2010 6:38 am

Dollar-Cost Averaging – The Easiest Way to Make $1 Million

 

Sticking with a long-term investment philosophy is one of those things that’s much easier said than done. Even the very best fund managers can experience losses for 50% of their clients, often because those clients pull money from the fund manager at the worst-possible time.

Almost any investment approach will experience periods of losses otherwise known as “drawdowns.”

If you believe in the long-term validity of the methods used to govern your long-term investments, then the worst thing you can do is sell into a drawdown or withdraw money from a fund manager while they are in drawdown mode.

This is especially true for fund managers who have a 15-year record of strong compound annual growth rates. Over time, those types of fund managers will invariably pull themselves out of drawdown.

The same is true for index investing: Over time, all the major indexes make higher highs.

It’s true that, in many cases, several years can go by before the index in question fully recovers. But if you are investing with a long enough time horizon, then it really doesn’t matter.

Make Drawdowns Work for You

One way to make drawdowns work for you is to use dollar-cost averaging.

Dollar-cost averaging simply consists of investing equal amounts of money at specific periods of time into a financial instrument (such as the S&P 500).

Dollar-cost averaging means that sometimes you’ll be overpaying for the market, like many did in 2008. But you’ll also be buying the market on the cheap, such as in March 2009 when the Dow fell below 7,000.

If you have absolutely no interest in investing in the market, but the idea of only getting a 1% return on your money at the bank makes you nauseous, then dollar-cost averaging may be for you.

Compound Your Returns With Dollar-Cost Averaging

The process is simple: Pick a specific series of time periods to add money to an S&P 500 index fund. It could be annually, quarterly or monthly. Just make sure that you pick an index fund that does not charge you a commission every time you buy into it, and one that also has very low management fees.

If you do that for 20 years (as well as re-investing your dividends back into the index), you’ll have about an 11% compound annual growth rate (CAGR).

While that return sounds low, an 11% CAGR will have you beating more than 85% of professional fund managers!

How to Make an Easy $1 Million

If you save just $5,000 per year for 30 years at a CAGR of 11%, you’ll have $1.1 million.

Many people will say, well, what’s $1.1 million worth 30 years from now?

And my reply is that it’s worth a darn sight more than if you have nothing in your savings account 30 years from now!

If you want to accelerate your retirement earnings, there are just two options: either invest more or generate a higher return. But if you are looking for a completely autopilot solution for beating 85% of all money managers, then this may be the approach for you.

 

A Little More Work Can Yield a Lot More Profits

If you want to do a little bit more work, you can create a performance edge for your retirement account by timing your entries into the S&P 500. However, the process that you use to time your entries cannot be discretionary — i.e., it can’t be you waking up one morning and saying, “Today I am going to buy the S&P.”

You can create an entry edge, but I do not suggest ever attempting to sell your existing position and then re-attempting to buy back cheaper. When you are investing for 20 years or more, it’s just not worth trying to sell and then buy back in. Your biggest long-term edge can come from timing your entries, though.

The key is to buy into the index during a drawdown period. The magnitude of the drawdown will be different for each investment period. In some years, you may see 50% drawdowns; in others, just a 12% drawdown.

So, you want to have an entry tool that is not so much dependent upon the size of the drawdown because, on a year-to-year basis, we simply cannot predict that. Rather, we want to employ a tool that tells us when the index is experiencing an oversold period based upon its long-term trading history.

Timing Your Entries With Bullish Percent Charts

You need to use specific technical tools that have a long proven track record of getting you into the S&P at historically cheap prices. One tool that can be very helpful for timing entries into major indexes like the S&P 500 are Bullish Percent charts.

Bullish Percent charts measure the amount of stocks in an index that are on a point-and-figure (P&F is a form of technical analysis) buy signal versus a P&F sell signal.

By timing your purchases through buying into an index when its BP chart is exhibiting an oversold reading, you put the drawdown recovery component inherent in every major index to work for you in your favor.

Buy and Hold on for Long-term Success

Remember, this is no silver bullet. You might buy into the S&P when it’s down 30% … only to watch it fall another 30%.

However, over a 20-year period, it won’t matter. And by specifically buying the index when it’s in drawdown, your overall rate of return could be far greater as the index recovers all of its lost value (and then some).

I recommend looking at some long-term charts of the S&P 500 and applying some different technical tools against the chart. Try to find some other technical indicators[1] that you can use to time your long-term investments into the S&P 500.

Compare your results to a dollar-cost averaging schedule that invests specific amounts on specific dates, and see which method holds up better over the historical testing period. This is very basic quantitative work that could boost your retirement investment returns dramatically.

I already shared with you that, if you can save $5,000 a year for 30 years at 11%, you’ll have $1.1 million. But if you can grind out an entry edge that yields just an extra 3% per year, or a CAGR of 14%, the same $5,000 per year will turn into more than $2 million.

Even with inflation, a $2 million nest egg that’s growing at 14% per year will fund a dignified retirement. 


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Endnotes:
  1. technical indicators: http://www.optionszone.com/learn-more/optionszone-experts/technical-analysis-101.html
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