Hallett explains volatility drag as follows:
“You’ve no doubt scratched your head at why a portfolio’s long-term performance hasn’t quite lived up to expectations. It’s likely that volatility drag is one of the big culprits. ... If a mutual fund reports a 7 percent 10-year rate of return, for example, the only way to have achieved that precise result was to invest at the beginning of that period, hold for the full decade and have no buys or sells in between. ... The investment industry has long preached the benefits of investing a regular dollar amount so that you buy more units of a fund when the price goes down and fewer when it’s up. This intuitive argument just doesn’t hold. ... Stock fund investors, however, might see returns that are 150 basis points (or 1.5 percentage points) less than published performance just from the fact that there are regular transactions over time.”This contradicted my understanding of the effect of dollar-cost averaging (DCA), but Hallett is a smart guy, and so I set out to investigate. I started with investment return data from a spreadsheet provided by Libra Investments. I focused on the real returns of the TSX from 1970 to 2010.
In the first experiment, I looked at rolling 15-year periods. For each period, I calculated the average compound return from investing a lump sum at the beginning of the period and holding it for the full 15 years. The average compound return across all periods was 6.19%.
Then for each period, I considered the case where an investor makes an equal size investment at the start of each year for 15 years. For each period I calculated the internal rate of return (IRR). With this method of calculating return, we don’t penalize DCA for having less money invested in the early years. Across all of the 15-year periods, the average return was 6.52%, which is more than the average lump-sum return.
Of course, this victory for DCA may be just a quirk of the particular set of returns I used. While the DCA approach edged out the lump-sum approach on average, the results for individual 15-year periods varied. The full range was from DCA winning by 3.07% from 1973 to 1987 (inclusive) to DCA losing by 2.38% from 1978 to 1992 (inclusive).
The reason why DCA performs differently from lump-sum investing is that with DCA there isn’t much money invested in the early years. If the early years have better returns than later years, then lump-sum investing will win, and if the early years have lower returns than later years, then DCA will win. The fact that the TSX was down nearly 40% in 1973-74 and up nearly 60% in 1978-79 tells us why DCA beat lump-sum starting in 1973, but lost starting in 1978.
To factor out this dependence on the order of returns, I did a second experiment. I used 12 years of TSX return data from 1999 to 2010 inclusive. For every possible reordering of the 12 years of returns I calculated the DCA return. (There are nearly half a billion cases and it took a program 12 minutes to check them all. To do the same for 15 years of returns would have taken about 3 weeks, and I’m not that patient.)
The DCA return results ranged from -1.81% to 15.82% with an average of 6.55%. The lump sum compound return is the same in every case: 6.27% per year. So we see that DCA returns can differ from lump-sum returns by quite a bit, but on average, the DCA returns are slightly better. In fact, the DCA return was higher than the lump-sum return in 52.3% of the cases.
I can’t find any evidence that Hallett’s volatility drag exists. Either one of us is wrong, or we are calculating different things. There is another type of volatility drag that comes from compounding, but this applies to both lump-sum investing and dollar-cost averaging.
For investors who are enthusiastic about dollar-cost averaging, these results do not apply to the case where you have a lump sum and choose to invest it slowly over a period of time. This is because of the opportunity cost of the lost returns on money waiting to be invested.