Volatility is an investors friend.
Stock and bond market volatility are back. Thank goodness. While many might find the daily swings unsettling, volatility can be an investor’s friend.
How can investors use volatility to their advantage?
Another old friend – Dollar Cost Averaging (DCA).
DCA is simply investing a fixed dollar amount at regular intervals. It’s an effective wealth building strategy that is well suited to volatile markets. It isn’t new. Many already use a form of DCA through payroll deduction at work.
By investing on a regular basis, DCA aims to reduce the effect of volatility. The investor buys more when the market is down and prices are on sale and less when the market is up and prices are higher. The effect of market fluctuations is less prevalent over time.
The math works but it’s the non-emotional discipline that makes the DCA strategy so effective. No market timing is necessary. Hesitate and you could miss out. Chase recent market gains and you might invest at a peak. So the investor can avoid the dilemma of when to jump in to or sit on the sidelines. The discipline of a regular investing program helps ease the pain of market volatility.
Still, many investors hate volatility. But if you are still building your wealth, then you are not done buying and volatility is your friend. In fact you need volatility to invest at bargain prices. More volatility means better bargains and greater DCA benefits as your investments average cost over time.
An example of DCA’s practical application is the investor burned by Income Trusts.
If investors hate volatility – they loathe losses. Some hate losses so much that they hang on to their losers. The once burned might be twice shy about selling and reinvesting. But their Trusts may never recover. Selling a loser, however, means capturing the tax credit and applying it against future gains. The after-tax benefit to a portfolio from a tax loss sale of an individual holding can be significant.
Add a DCA strategy to redeploy sale proceeds and the once burned can ease into a properly diversified portfolio in an orderly fashion. No one-time leap of faith is required. $400k worth of Trusts can be sold (all or part) and the proceeds re-invested $100k in each of the next four quarters, say. Regardless of market direction, this investor is better off with the tax credit and a more diversified portfolio. DCA helps the transition – it smooth’s the emotional ride.
DCA has broad appeal. The new-to-money investor might invest a $1.5m win fall $100k a month for 15 months, say. Others might invest ½ now, ½ later. And those reinvesting income distributions from existing investments will benefit from DCA’s automatic rebalancing effect.
In any case, investors can use the DCA investment strategy as a sort of on-ramp to volatile markets.
Originally published in the Business Thompson Okanagan news, September 2007.
Doug Cronk CFA is Manager, Investments for a Canadian Pension Fund.