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Dollar-Cost Averaging Using the CAPE Ratio: an Identifiable Trend Influencing Outperformance by Jon M

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Dollar-Cost Averaging Using the CAPE Ratio: an Identifiable Trend Influencing Outperformance by Jon M CONTRIBUTIONS Luskin Dollar-Cost Averaging Using the CAPE Ratio: An Identifiable Trend Influencing Outperformance by Jon M. Luskin, CFP® Jon M. Luskin, CFP®, is a financial planner with Executive Summary Define Financial, a fee-only planning firm based in San Diego, California, and an active member of the • Previous research has usually when ignoring taxes and transac- FPA of San Diego NexGen group. For his master’s shown that dollar-cost averag- tion costs. thesis, Luskin showed how university endowments ing underperformed lump-sum • The likelihood of dollar-cost averag- can generate more wealth and take on less risk by investing. However, the body of ing outperformance over lump-sum adopting simpler investment strategies. existing research has not closely investing is a function of the examined the circumstances of this cyclically adjusted price-to-earnings Acknowledgement: The author thanks Meghaan outperformance. (CAPE) ratio at the beginning of Lurtz, personal financial planning doctoral student • Concurrent with existing research, the investment period, with higher at Kansas State University, for her editing help. this paper found that lump-sum CAPE ratios linked to dollar-cost investing outperformed dollar-cost averaging outperformance. INVESTMENT ADVISERS have averaging roughly two-thirds of • This paper discusses entry-level continued to practice dollar-cost the time on a nominal return basis, investment analysis. averaging despite its demonstrated inferior returns compared to lump-sum In practice, dollar-cost averaging is invested on the first of every month. investing (Williams and Bacon 1993; most effective as a behavioral finance As mentioned, DCA is traditionally Shtekhman, Tasopoulos, and Wimmer tool (Statman 1995). Investment advis- used as a risk mitigation strategy; DCA 2012). However, lump-sum investing ers proposing a dollar-cost averaging may prevent or palliate buyer’s remorse has not conclusively eclipsed dollar-cost approach have likely done so in an effort in the event of a market crash or correc- averaging; it has outperformed dollar- to reduce risk and minimize potential tion. DCA systematically invests small cost averaging only two-thirds of the emotional regret on behalf of the client, amounts over time and assists clients time (Shtekhman et al. 2012; Williams not grow assets (Dubil 2005). Thus, in mentally navigating the proverbial and Bacon 1993). Certain periods of flat even though dollar-cost averaging is concern of “going all in.” stock market performance (Williams not conventionally used as a superior Lump-sum investing (LSI) takes the and Bacon 1993), and downward-trend- wealth-generation tool, are there still opposite approach. LSI requires invest- ing markets (Greenhut 2006) point to opportunities for it to be an effective ing the entirety of an available asset at the superior nominal investment return portfolio strategy? the inception of the investment period, with dollar-cost averaging. This presents instead of making smaller investments the research question: is there a com- Conceptual Framework over time. mon underlying factor that influences The most important concepts and The Shiller Price-to-Earnings (P/E) 10 dollar-cost averaging outperformance of their definitions and acronyms are as is a stock market valuation metric based lump-sum investing? follows: on the average corporate earnings of This study sought to identify an Dollar-cost averaging (DCA) is the domestic companies over the last 10 environmental pattern in dollar-cost process of making a regular deposit at a years. This metric adjusts for inflation averaging’s higher returns over lump- regular time interval. For example, instead and is also known as the cyclically sum investing. of investing $1,200 on January 1, $100 is adjusted P/E (CAPE) ratio. 54 Journal of Financial Planning | January 2017 FPAJournal.org Luskin CONTRIBUTIONS A Theoretical Overview: Known and allocation in response to changes in vidual domestic equities, LSI usually Hypothetical Relationships equity valuation has been shown to generated superior nominal and Positive long-term market returns. produce superior nominal investment risk-adjusted investment returns over On average, LSI has outperformed returns relative to a strategic (i.e., DCA (Williams and Bacon 1993; DCA given the stock market’s historical static) portfolio. Research has shown Shtekhman et al. 2012; Leggio and upward trend. This upward trend is most that in highly valued markets, a tactical Lien 2003). Previous studies provided prominent on long timelines, such as 15 portfolio with equities underweighted insight into DCA’s circumstantial years or greater. Inherent stock market can outperform a static portfolio. The dominance yet neglected a detailed volatility, however, may create short-term inverse was also found; given supposed discussion of determining factors. losses. As noted in other literature, vola- low market valuations, a portfolio with This paper intends to pick up where tility and downward markets have proved equities over-weighted would outper- that previous research left off. DCA to be the superior investment form a static portfolio (Solow, Kitces, Shtekhman et al. (2012) reviewed strategy, producing a higher nominal and Locatelli 2011). historical data from the equity investment return than LSI (Greenhut Modern portfolio theory. As markets of three different first-world 2006, Williams and Bacon 1993). mentioned, the traditional risk/return countries from 1926 to 2011, examin- Risk and return. Risk and return are principle posits that greater invest- ing periods between one and 30 positively correlated: a single asset class ment return can only be achieved by years. They found in congruence with generates a greater expected investment enduring greater risk when investing existing research, DCA only outper- return at the consequence of greater in a single asset class. However, a DCA formed LSI one-third of the time. risk. Complimentary to this theory is strategy uses a portfolio composed of In those circumstances where DCA the principle that DCA is traditionally two very distinct asset classes: equities outperformed, the authors explained, less risky than LSI (Dubil 2005; Kitces and cash. Juxtaposing distinct asset “ … we found that DCA performed 2016). A DCA strategy, on average and classes within the same portfolio is a better during market downturns, so over time, holds more cash than a LSI principle of modern portfolio theory, DCA may be a logical alternative for strategy. Holding cash or cash equiva- which posits superior risk-adjusted investors who prefer some short-term lents has historically proven to be less performance is available when holding downside protection” (page 6). volatile than holding domestic equities. asset classes with low correlation to Williams and Bacon (1993) studied Therefore, a traditional portfolio each other (Markowitz 1952). one-year holding periods, investigat- holding a greater proportion of cash, ing the value of DCA in the domestic on average, will be subject to less risk. Research Question Addressed in market. The period analyzed ran from The opposite is also true; the portfolio This Study 1926 to 1991. The authors reached a holding a greater proportion of equities A multi-year valuation metric has been similar conclusion to Shtekhman et al. will be riskier and should, theoretically, shown to be a successful tool for produc- (2012): LSI outperformed two-thirds generate higher investment returns. ing excess investment returns (Solow of the time. The authors noted the Despite the previous principles, et al. 2011). As such, the CAPE ratio (a following exception: “The success of certain periods have exhibited the multi-year valuation metric) may also be lump-sum investing was somewhat less dominance of a DCA strategy over useful in indicating the standards and during the 1970–91 period because LSI. DCA has produced higher circumstance by which a decision to of the poor performance of the stock nominal investment returns given flat, employ DCA or LSI is made. market during much of the 1970s” downward-trending, or volatile market The research question addressed in (Williams and Bacon 1993, page 66). conditions (Shtekhman et al. 2012). this study is: Can a pattern of market Greenhut (2006) examined Tactical asset allocation and valuation be identified that alerts individual companies, as opposed multi-year valuation metrics. Related investment advisers to when using to market indices, over 10 years to DCA is t he concept of tactical asset DCA may be the superior strategy— from 1995 through 2004. His study allocation—adjusting portfolio alloca- generating a higher nominal invest- highlighted the same observation: “ tion in response to dynamic market ment return over LSI? … the performance of DCA rests on variables. One variable that affects allo- the trend in stock prices, with DCA cation is equity valuation (the CAPE Literature Review outperforming in downward markets ratio is one method for measuring When back-testing historical data and lump sum outperforming in equity valuation). Adjusting portfolio using one or more indices or indi- upward markets” (page 76). FPAJournal.org January 2017 | Journal of Financial Planning 55 CONTRIBUTIONS Luskin process for one to postpone investing Figure 1: 15-Year Annualized S&P 500 Price Appreciation vs. the CAPE Ratio at the Beginning of 15-Year Periods, the majority of their asset pool. The 1881–2016 investor using DCA has the opportunity to buy lower later, after market valua- 18% tions have normalized or inverted below mean valuations. 13% What makes this study significant, with respect to the existing literature, is 8% the evaluation technique. Previous work has evaluated whether LSI or DCA is 3% better. This study sought to determine why. Again, the prior literature on DCA –3% has fallen short of offering a possible strategy to capitalize on those identified Annualized Price Appreciation Price Annualized –8% market trends where DCA outper- 4 9 14 19 24 29 34 39 44 formed. This paper utilized a demon- CAPE Ratio at Beginning of 15-Year Period strated evaluation strategy, CAPE/Shiller P/E 10, to inform and enable advisers so they make take advantage of DCA.
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