When Price Drops Occur (2 Stage DCA and VII)

I looked at dollar cost averaging (DCA) and varying allocations in accordance with valuations (Valuation Informed Indexing VII). I used different algorithms for the first and second fifteen years.

This version was decidedly inferior to using Valuation Informed Indexing throughout.

Two Algorithms

During the first 15 years, I invested entirely in stocks when P/E10 was below 20. I invested entirely in 2% TIPS when P/E10 was 20 and above.

During the next 15 years, I applied traditional Valuation Informed Indexing, easing into stocks when P/E10 fell below 20 and investing heavily whenever P/E10 fell below 14. I maintained a minimum stock allocation of 20% when P/E10 was above 20 but below 30. Above 30, I reduced my stock allocation to zero.

Scenario Surfer Runs

I invested entirely in stocks and 2% TIPS. I started with a $1000 balance. I selected P/E10=26 Bear Market. I deposited $1000 (plus inflation) each year. Here are the Year 30 balances. I varied allocations in accordance with valuations as measured by P/E10. P/E10 values are in “Current Years” in the “Portfolio Allocation” box.

Run 1.
P/E10 below 20 in Year 3.
P/E10 below 15 in Year 11.
P/E10 below 10 in Year 19.
20% rebalanced: 47,786.
50% rebalanced: 53,461.
80% rebalanced: 57,113.
2 Stage Valuation Informed Indexing: 70,837.

Run 2.
P/E10 below 20 in Year 6.
P/E10 below 15 in Year 10.
P/E10 below 10 never.
20% rebalanced: 53,415.
50% rebalanced: 70,515.
80% rebalanced: 88,235.
2 Stage Valuation Informed Indexing: 102,974.

Run 3.
P/E10 below 20 in Year 11.
P/E10 below 15 in Year 11.
P/E10 below 10 in Year 17.
20% rebalanced: 53,540.
50% rebalanced: 71,371.
80% rebalanced: 91,202.
2 Stage Valuation Informed Indexing: 109,599.

Run 4.
P/E10 below 20 in Year 7.
P/E10 below 15 in Year 9.
P/E10 below 10 never.
20% rebalanced: 47,170.
50% rebalanced: 52,870.
80% rebalanced: 57,820.
2 Stage Valuation Informed Indexing: 70,702.

Run 5.
P/E10 below 20 in Year 11.
P/E10 below 15 in Year 12.
P/E10 below 10 never.
20% rebalanced: 46,608.
50% rebalanced: 51,152.
80% rebalanced: 54,410.
2 Stage Valuation Informed Indexing: 52,742.

TIPS only baseline:
Zero % stocks: 43,191.

Data Summary

Here are the balances ordered in terms of when P/E10 first falls below 20:

P/E10 below 20 in Year 3: balance 70,837.
P/E10 below 20 in Year 6: balance 102,974.
P/E10 below 20 in Year 7: balance 70,702.
P/E10 below 20 in Year 11: balances 109,599, 52,742.

Here are the balances ordered in terms of when P/E10 first falls below 15:

P/E10 below 15 in Year 9: balance 70,702.
P/E10 below 15 in Year 10: balance 102,974.
P/E10 below 15 in Year 11: balances 70,837, 109,599.
P/E10 below 15 in Year 12: balance 52,742.

Here are the balances ordered in terms of when P/E10 first falls below 10:

P/E10 below 10 in Year 17: balance 109,599.
P/E10 below 10 in Year 19: balance 70,837.
P/E10 below 10 never: balances 102,974, 70,702, 52,742.

Here are the P/E10 thresholds versus the ordered Year 30 balances:
109,599 and years 11, 11 and 17.
102,974 years 6, 10 and never.
70,837 and years 3, 11 and 19.
70,702 and years 7, 9 and never.
52,742 and years 11, 12 and never.

Data Analysis

In all instances, owning stocks proved beneficial.

In all instances, an 80% stock allocation was best among fixed allocations.

Varying allocations produced the largest final balance in 4 out of 5 instances.

This algorithm removed sensitivity to when price drops occurred. I observed no clear cut relationship.

This algorithm is decidedly inferior to using Valuation Informed Indexing throughout.

Conclusions

This two stage dollar cost averaging algorithm is inferior to using Valuation Informed Indexing throughout.

This two stage dollar cost averaging algorithm removes the sensitivity as to when price drops occur.

Have fun.

John Walter Russell
May 19, 2008