I also thought that the volatility of many stocks would work in a Drip investor's favor. It seemed that stocks with strong moves relative to the average market indices might benefit from dollar cost averaging. The measure of this volatility is "beta." A stock with a beta of one moves up and down, lockstep, with the market, while a stock with a beta of two moves twice as much as the market, and so on. Theoretically, if the market goes up or down 10%, a stock with a beta of one will do the same, whereas a stock with a beta of two would move 20%.
Here is why I think Drip investors can benefit from volatility:
- The short-term movements of stocks are driven by random events that can't be predicted.
- By investing on a certain date every month, you have just as much chance of getting a short-term down as you do a short-term up.
- Picking a stock's top or bottom is impossible.
- Stocks with wide fluctuations will provide better returns on dollar cost averaging, since by investing regularly you may purchase more shares at lower prices than you would with stocks that fluctuate less.
How do you test a hypothesis like this? I originally thought about picking a number of low-beta stocks and high-beta stocks at random and comparing the results of dollar cost averaging them. However, in a bull market, the high-beta stocks will by definition have a larger average annualized return than the lower-beta ones. How can you really compare the results?
If we are dollar cost averaging once a month, we'll get an average annualized return. If the system works better with high-beta stocks, that average return should be much higher than the annualized return of most of the months we invested. Let's say we invested $100 a month for 36 months and our average annualized return is 60%. If only nine months provided 60% or higher return, that 60% is the 75th percentile. That's because for 27 months (75% of the investments) we did not reach a 60% return. That would tell us that 75% of the times we could have invested we would not have beaten the results of dollar cost averaging.
To get my data, I selected 10 stocks with a beta of three or greater, and 10 with a beta of one. Both sets were selected randomly using Fidelity's website to screen stocks by beta. I averaged the returns from the first two years of investing, and the third year I didn't count so we wouldn't be thrown off by extreme short-term results. For a couple of the stocks, the annualized returns of the past few months put the average results into the triple digits -- obviously that isn't something we'll see year in, year out.
Beta > 3.0
Average annualized return from Dollar Cost Averaging: 245.95%
Percentile Ranking: 59.33%
Beta = 1.0
Average annualized return from Dollar Cost Averaging: 28.84%
Percentile Ranking: 55.31%
From the limited data here, the back test shows dollar cost averaging gave much larger returns for the high-beta stocks. That's to be expected (because these stocks gained much more), but it's looking back over a bull market at stocks that have maintained a high volatility. If we had a bear market, I'm sure you'd see some huge losses. About 60% of the time you could have invested in the high-beta stocks in that period, you would not have beat the average annualized return for the dollar cost averaging. But wait! My results for stocks with a beta of one aren't that much lower -- about 55%, only a 5% difference. So dollar cost averaging helped you about equally for both types of stocks.
Does dollar cost averaging give better results for the high-beta stocks? Should you forget your Drips in Pfizer, Johnson and Johnson, and Coke, and move over to synthetic Drips in Yahoo!, eBay, etc.? Your possible returns are much higher (buying higher-growth companies, generally), but so is your risk. The results of the volatility on your average return aren't that much higher than lower-beta stocks, though. I suspect this difference would disappear with an even larger sample. So, in conclusion, while the higher-beta stocks present a possibility of a higher return, dollar cost averaging them does not give you much of an edge over what it does with lower-beta stocks. It still comes down to your tolerance for risk vs. your desired return.