The Investment Scientist

This is How to Build More Wealth in a Worse Market

Posted on: June 30, 2017

Investment-Planning_Lump-Sum-vs-Dollar-Cost-Averaging.jpgRecently, I shared a true story in which I set up a client’s 401k plan five years ago with periodic (bi-weekly) contributions and equal investments into both a US stock index fund and an international stock index fund. Despite the fact that the US index (fund) has outperformed the international index (fund) by a huge margin: 86% vs 29% over the last five years, my client now has more money in the international fund than in the US fund. What gives? I invited my readers to think about it and give me their explanations. Now it’s time to reveal the answer: it’s dollar cost averaging!

Let me show you a stylized example in a three time-period world. There are two indexes. Index A goes from 100 to 105, then 110. Index B goes from 100 to 80, then 100. It’s clear that index A dominates index B since the total return of index A is 10%, that of index B is 0%. Yet an investor who makes equal $100 periodic investments in both index A and B will have more money in B at the end. Here is the math …

At the end of the first two periods, the investor has (100/100+100/105) = 1.95 shares of A, and (100/100+100/80) = 2.25 shares of B. Since the final price of A is 110 and B is 100, he has 1.95*110 = $215 in A and 2.25*100 = $225 in B. He makes more money with a lagging index!The lesson I want all of you to learn is not just the technicality of dollar cost averaging, but also the fact that much of our worry about a bad market is unnecessary. If you are in wealth accumulation phase, which for most people is the time before retirement, you should pray that the market turns bad from time to time so you can pick up cheap shares!

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Author

Michael Zhuang is principal of MZ Capital, a fee-only independent advisory firm based in Washington, DC. He is also a regular contributor to Morningstar Advisor and Physicians Practice. To explore a long-term wealth advisory relationship, schedule a discovery meeting (phone call) with him.



You may also get his monthly newsletter, or join his Facebook page for regular wealth management insights. Michael's email is info[at]mzcap.com.

Twitter: @mzhuang

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