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I've read that if you dollar-cost-average, then you'll end up with more money investing in a volatile fund with returns that go up and down like a roller coaster rather than if you invest in a more stable one. Is this true? And if so, does it mean I should look for volatile funds if I'm investing regularly but less volatile ones if I'm not adding new money to an account?
-- Bob Zak, Frederick, Maryland
I don't think there's any doubt that dollar-cost-averaging -- investing small amounts of money regularly over time rather than investing your cash all at once -- can reduce the risk of investing in a volatile fund, or any fund for that matter.
Indeed, this is one of the main reasons everyone from investment firms to financial planners to personal finance writers have touted dollar-cost-averaging as an investing strategy. I largely agree with that notion and think dollar-cost-averaging is an acceptable strategy for many investors, although for a lot of technical reasons too complicated to go into here, dollar-cost-averaging is hardly the most effective way to reduce investing risk.
But to say, as some people do, that you're more likely to end up with more wealth by dollar-cost-averaging into a very volatile fund than a less volatile one, well, I don't buy that.
Volatility is not automatically better
Sure, it's possible that dollar cost averaging into a volatile fund may beat making the same investment in a more stable fund. But there's nothing inherent about volatility guarantees you'll end up with more money by investing regularly in a volatile fund. And you could just as easily do better in the less flighty fund.
To prove this, let's engage in what Albert Einstein called a "thought experiment."
Assume you plan to invest $5,000 a year for five years and have a choice between two funds: the Steady Eddie fund and the Roller Coaster fund. And let's assume both funds will return an annualized 8 percent over the course of the five years you invest.
As its name implies, Steady Eddie earns that return, gaining exactly 8 percent each and every year.
The Roller Coaster, not surprisingly, gives more of a white-knuckle ride. It loses 20.5 percent the first year, loses another 10.5 percent the second year, recovers for a 10.5 percent gain the third year, surges to a 20 percent gain the fourth year and then finishes with a bang, a 55.7 percent gain the fifth year.
Those returns, however, still translate to an 8 percent compound annual gain over the five years, the same as Steady Eddie's annualized gain.
Which fund would increase the value of your $5,000-a-year investment more? Well, if you do the arithmetic, you'll find that at the end of five years you would have ended up a lot more in the Roller Coaster fund than the Steady Eddie fund: $44,034 vs. $31,680. So case closed, right. The more volatile fund wins.
Not so fast.
What if the Roller Coaster fund had the exact same annualized return and even the exact same annual returns, but the order of the returns was reversed?
In other words, let's say market conditions were such that, instead of getting the lousy returns first and the stellar returns at the end of the period, the fund started off with a bang and ended with a whimper, gaining 55.7 percent, then 20 percent, then 10.5 percent, then losing 10.5 percent and then losing 20.5 percent? Could happen, right? Nothing says returns have to play out any particular way.
Guess what. Do the arithmetic based on the new sequence of returns and the Roller Coaster fund ends up with $23,526, much less than Steady Eddie's $31,680. The fund is just as volatile as before, but it didn't come out a winner.
Random chance and investing
So what does our little "thought experiment" tell us? Well, it tells us that volatility can work in your favor, but whether it does or not is largely dependent on the time period you choose and how the returns play out over that period.
If you get lousy returns at the beginning of the period and great returns at the end, volatility works in your favor because the higher returns are applied to more of your capital. If the reverse is true -- you get the best returns at the beginning and horrible ones at the end -- then volatility works against you.
If you're investing a lump sum, then the volatility of returns doesn't affect the amount you end up with at the end. As long as the two funds have the same annualized return over the period, you'll end up with the same amount of money regardless of how much the returns jump around or the order in which they unfold.
As a practical matter, of course, you're not going to find a mutual fund that delivers returns of 8 percent like clockwork year after year (certainly not if it's investing in stocks, or even bonds for that matter).
In the real world, the choice is really going to be between funds with varying levels of volatility. Also, in the real world, you would expect the higher volatility fund to deliver larger gains to compensate for the higher risks it takes (although those higher gains aren't guaranteed and don't always materialize).
So in the sense that a higher volatility fund should provide higher gains, you might indeed end up with a higher return and more money by investing in a high volatility fund. But it's not the volatility that's increasing your wealth, it's the higher return.
Your investing strategy
What does all this mean for your investing strategy? Well, I don't think it's a good idea to have one set of funds for dollar-cost-averaging and another for accounts you won't be adding new money to. (Actually, even that distinction doesn't make sense when you consider you'll probably be reinvesting dividends and capital gains in those accounts anyway. So new money is actually flowing in.)
In fact, I think it's a lousy idea because it diverts attention from what should be your priority: having a variety of funds of different styles and different levels of volatility -- stock funds and bond funds, large- and small-cap, growth and value, etc. -- that work together as a coherent whole.
So my recommendation is that you focus more on putting together a lineup of funds that complement one another and ignore this impractical idea of leveraging volatility.
Like so many other half-baked ideas that surface from time to time in the financial press, this is just another of the investment world's equivalent of a stall at a carnival sideshow: something that catches your interest for a moment, but is ultimately not very meaningful.
Walter Updegrave is a senior editor at MONEY Magazine and is the author of "We're Not in Kansas Anymore: Strategies for Retiring Rich in a Totally Changed World."