Dollar cost averaging with margin is the fool proof way to profit

What is dollar cost averaging (DCA)?

If you contribute to any retirement account that invest in the stock market, you are using the dollar cost averaging technique. Investopedia defines dollar cost averaging as

“The technique of buying a fixed dollar amount of a particular investment on a regular schedule, regardless of the share price. More shares are purchased when prices are low, and fewer shares are bought when prices are high.”

Because you catches more shares when prices are low, over a long period of time the average cost per share will be significantly below the peak price of the stock. As long as the market will return to previous highs, or even better, reach new highs,  which the market has done so in more than 400 years, you are certain to gain above average returns.

DCA in action

spy

The power of Dollar Cost Averaging is best illustrated with a real life example. I have assumed that $1000,000 was invested at the very peak of exchange traded fund SPY (which tracks the S&P 500 index) in July 2007, then subsequently $5000 was added each week until the index reached another high in 2013. You can download the excel file here that shows the result. You can see that although a large sum of money was invested right at the peak of the index, the portfolio value broke even when the price of SPY was still 18% below the previous high. When the price returned to previous high, the portfolio returned a handsome $453k in profit on $2.47m invested, that’s not counting the near $200k made in dividends!

But in Retirement I won’t have extra funds to DCA

The statement is quite true. Our 401k or IRA works because we are employed and have a stable source of cash flow to invest in the DCA style. If we liquidate our positions to apply the cash generated to DCA, we will not be fully invested and may miss out on significant upside of the market. How then can we apply the DCA technique in our retirement? Actually, there is a solution, that is, to use margin. Whenever people talk about margin, everyone is freaked out about the risk. It’s true margin involves significant risk, but in the capitalist economy, leverage is the most efficient way to get rich. The ability to borrow money is the cause of all the problems in the capitalist economy, but it is also the main cause of income disparities. Rich people know how to profit from other people’s money, middle class people understand the importance of investing their own money, and poor people just let their money sitting there doing nothing. We can’t ban the ability to borrow money to make the economy more efficient, but we can take advantage of it to walk our ladders up.

The benefits of both worlds

The most prominent critics of dollar cost averaging is that if you don’t invest the whole lump sum at once, there’s an opportunity cost of missing most of the market gains on the uninvested funds. The concern is absolutely right, We SHOULD ALWAYS INVEST ALL OUR OWN FUNDS AT A LUMP SUM, NO MATTER HOW HIGH THE MARKET IS. The only time you should DCA is when the investable funds come in installments, such as salaries, or when you can use other people’s money for the purpose. A margin loan is a perfect fit for DCA purposes, in this case all of your own money is fully exposed to all the market gains, while other people’s money is working to reduce the risk of market fluctuation for you. With margin loan as the tool for dollar cost averaging, you really can benefit from the best of both worlds. Margin is of course associated with risks, that’s why you have to make sure the margin ratio is large enough that even in the worst case scenario there won’t be a margin call, and ideally the margin rate is lower than the dividends rate. The best broker for this purpose is Interactive Brokers, with their portfolio margin option, you can borrow up to 5 times your equity, and the margin rate is currently only 1.6% which should be easily covered by the dividends of most funds that tracks the S&P 500, most of them currently pay above 2%. The trading fee of Ineractive Brokers is also pretty low. With limit orders above 200 shares each, I find the fee is roughly 20c each 100 shares, for SPY which is currently in the $200 range, the commission is only about 0.001%! However, to benefit from this low fee each trade need to be at least $40,000, which is prohibitive for the dollar cost averaging technique on a single account. Even if we trade SCHX, which can reduce the requirement to $10,000 each trade (fees will be 0.004%, still low enough), it’s still prohibitive. Luckily, with Interactive Brokers, we have the option to share the trade across multiple accounts to take advantage of the low fee structure. I’ve also developed some fine tuning techniques to DCA more efficiently, it probably will only add a few tenth of a percentage point to the annual return, but it’s definitely noticeable. You can find out more about how you can benefit from sharing cost and my fine tuning technique while maintaining full control of your account here.

How to use margin to invest in retirement

Nothing is more convincing than a real life example. Again with the above spy DCA example, suppose the $1 million invested at the height of the housing bubble is your retirement money, and you have no other sources of income. The $5000/wk extra investment for DCA all come from margin lending. You can see from the example that although equity of the account dropped to $445k at the market bottom, at no stage during the whole downturn was the margin ratio above 2 (anything below 5 won’t trigger margin calls). As the margin interests are fully covered by the dividends, the dividends generated by the initial units you bought with your own funds can be used for day to day expenses. These work out to be around $20k/year, if your house is fully paid up, this may be sufficient. Anyway, if it’s not, you will always have the option to withdraw from margin since the ratio is pretty safe in this example. The profit made in the 5.5 year was $453k, which work out to be more than $80k/year, therefore withdrawing another $20k per year wouldn’t be too much problem for the portfolio. When the market did reach previous high, we should close all margin positions and start all over again to avoid the possibilities of future margin calls.

Although equity of the account dropped to $264k at the market bottom, at no stage during the whole downturn was the margin ratio above 2 (anything below 5 won’t trigger margin calls). As the margin interests are fully covered by the dividends, the dividends generated by the initial units you bought with your own funds can be used for day to day expenses. These work out to be around $20k/year, if your house is fully paid up, this may be sufficient. Anyway, if it’s not, you will always have the option to withdraw from margin since the ratio is pretty safe in this example. The profit made in the 5.5 year was $453k (7% annual return), which work out to be more than $80k/year, therefore withdrawing another $20k per year wouldn’t be too much problem for the portfolio. This is another advantage of using margin, as long as the margin buffer is sufficient, you can withdraw money on margin rather than liquidate your portfolio, therefore won’t lose any gain from the market.

The amount of each DCA determines how long you will last without a margin call

The above strategy is fool proof even in the Great Recession (2007), therefore any market downturns less serious wouldn’t be a problem. However, the strategy relies on the ability of the market to reach the previous high in a reasonable time frame (6-7 years), if the same $5000/wk DCA strategy was applied during the Great Depression (1929) or the Japan bubble (1989), when the index didn’t recover in 25-30 years, it would be disastrous. You can tweak the value of DCA in the excel spreadsheet to see the result, but basically  it reached margin call within 2 years. However, by reducing the weekly DCA to $500, it even survived the Great Depression. This is shown in the doww tab of the excel file above, basically by Nov 1950, the portfolio finally broke even. Therefore, by reducing the amount of DCA it’s possible to weather even the worst crisis. However, the less amount also means less annual return later on.

djia40 nikkei

 

How much you should DCA depends on how severe you anticipate the down turn will be. As shown in the above graphs, both the Great Depression and the Nikkei bubble were preceded by an enormous upswing, such an abnormality is very easy to spot out, so we could adjust the amount to DCA if we found such an anomaly. Furthermore, the reason that the two crisis lasted so long is because the central banks didn’t react correctly. There are two types of financial crisis, one is caused by lack of product, such as the ones happening in Venezuela and Zimbabwe; the other is caused by excess of product due to over investments, which is the ones usually experienced by modern capitalist economies. The reason that over investment happen over and over again is because of the ability to borrow money, which will be explained in another post. Anyway, when there’re excess products that people don’t have the money to buy, we should always do what Helicopter Ben (Bernanke) suggests, ie, to print more money and pour them to as many people as possible. People always fear printing money will cause inflation, actually that will only happen in the crisis caused by lack of product. In a recession caused by excess products, not printing money will only lead to deflation, and hence a vicious cycle that people anticipate lower prices so hesitate to buy, and without the return of capital factories had to dump excess products into trash and don’t have money to produce more product. The end result is huge deflation and a greatly reduced GDP which led to the total destruction of the stock market. Printing money in a controlled fashion will only prevent deflation, which is still inflation in a sense.

Nowadays the Fed is more wise and know how to react to such situations. As long as the Fed react correctly and the USD is still the global settlement currency, the Great Depression will not happen ever again in the US market, and the Great Recession is probably the worst we’ll ever see. The take home message: happy DCAing!

It all sound fantastic, but my retirement accounts aren’t allowed to trade on margin!

Bingo, that’s mostly true too. The average Joe is normally not allowed to trade on margin in their retirement accounts. But when there’s a will, there is a way. The law is highly influenced by the rich people, so they will always leave a back door for themselves. Mitt Romney is using the trick to amass a $102 million IRA in 2012. I will show you how you can take advantage of the system to be able to trade on margin while maintaining all the tax benefits of a retirement account in this EBook. The benefit of DCA with margin will become obvious when your account value increase above $100k, when the $18000 limit we can contribute to 401k will not be enough for effective DCA. With margin, we can DCA with 1/4 to 1/3 of the peak account value per year in most circumstances without a margin call. We certainly may not be as successful as Mr Romney, but being better than the average Joe is a promise I can make.

Read More