Imagine that you’re given the choice between:
- Investing $1,000 in an investment with a fixed 8% annual return, or
- Investing $1,000 in an investment that has averaged an 8% annual return over its life, but has historically been rather volatile, earning a positive return in some years and negative return in others.
Which would you choose? I’d imagine that most people would choose the one with a fixed return. In fact, that’s likely the one I’d choose as well.
Now imagine this slightly different scenario: You recently came upon a new income stream of $1,000 per year. You don’t need the money, so you plan to invest it. Your two options are:
- Investing $1,000 per year in an investment with a fixed 8% annual return, or
- Investing $1,000 per year in an investment that has averaged an 8% annual return over its life, but has historically been rather volatile, earning a positive return in some years and negative return in others.
In this scenario, which option would you choose? The fixed rate still feels rather attractive. Dealing with uncertainty is difficult, so it’s nice to know exactly what you’re going to get.
On the other hand, if the volatile investment continues to earn an 8% annual return on average–even though it’s year-by-year returns fluctuate a great deal–it’s going to earn you more money.
Why is this?
When dollar-cost-averaging, greater volatility means greater returns. It doesn’t necessarily seem intuitive, but let’s look at the math. [Please note that the following analysis applies only when dollar-cost-averaging into an investment.]
Scenario 1
The following spreadsheet snippet shows our zero-volatility example. (You’re investing $1,000 per year, and the investment earns exactly 8% each year.) As you can see, at the end of the period, you would have invested $3,000, and it would have turned into $3,506.
- Average return earned by the investment: 8%
- Volatility: None
- Amount of money at the end: $3,506.11
- Return earned on your investment: 8%.
Scenario 2
This next spreadsheet shows a scenario in which the investment still averaged the same exact 8% annual return. (That is, it still started at a $100 share price and three years later had a share price of $125.97.) However, in this scenario–in Years 2 and 3–the investment fluctuated in price from our base-line, 8%-every-year scenario. This time, instead of the share price in Year 2 being $108, it was $128 (or $20 higher). And in Year 3, instead of $116.64 it was $96.64 ($20 lower).
- Average return earned by the investment: 8%
- Volatility: $20 upward, followed by $20 downward
- Amount of money at the end: $3,547.34
- Return earned on your investment: 8.62%.
As you can see, adding some volatility into the scenario did, in fact, increase your return. In short, this is because Dollar-Cost-Averaging into a volatile investment sets you up to automatically take advantage of price swings by buying more shares when the price is low.
OK, so volatility helps your return in that scenario. But what about in other situations? For example, what happens when the price swings happen in the other order (downward first, followed by upward)?
Scenario 3
This scenario is exactly the same as Scenario 2, but with downward volatility first, followed by upward volatility. So the share price in Year 2 is $88 ($20 lower than the original $108), and in Year 3 the share price is $136.64 ($20 higher than the original $116.64).
- Average return earned by the investment: 8%
- Volatility: $20 downward, followed by $20 upward
- Amount of money at the end: $3,613.09
- Return earned on your investment: 9.59%.
As you can see, the results are even better than in Scenario 2.
So far, we can conclude that some volatility is better than no volatility and that it’s beneficial regardless of the order in which it occurs. So what happens when we increase the volatility further?
Scenario 4
Scenario 4 is the same as Scenario 2, except the volatility is in the degree of $50 rather than $20.
- Average return earned by the investment: 8%
- Volatility: $50 upward, followed by $50 downward
- Amount of money at the end: $3,947.28
- Return earned on your investment: 14.36%.
Wow. Look at that return! Earning a 14% return on your money while investing in something that only earned an 8% return over the period is pretty impressive.
Why does volatility increase returns?
- When you’re DCA’ing into an investment, you’re automatically buying more shares when the market is low, and fewer when the market is high. (“Buy low. Sell high.”)
- Increased volatility simply creates a situation in which the market lows are lower, thereby making your DCA’ing more effective.
Overall Lesson
If you’re dollar-cost-averaging into an investment, greater volatility means greater returns. In other words, the volatility of the stock market isn’t just something you have to put up with in order to earn superior returns. It’s actually an essential factor that directly improves your return.
November 24, 2008 4 comments
