Friday, February 15, 2008

Dollar Cost Averaging

The media is constantly bombarding us with news about the US housing bubble, rogue traders, recession, bear market and many other ominous headlines. Unless you are a day trader who watches the market tick by tick I would advise you to ignore the noise. Most advisers tell you instead to focus on the big picture and follow your long-term goals of adding a fixed amount of money into stocks, which are automatically deducted from your paycheck. By spreading your purchases over time, you are a buyer when the market is overvalued, but you are also a buyer when the market is severely undervalued. In the end it would all even out for you. Those advisers recommend to their clients that they do not purchase everything at once but follow a disciplined approach to investing by putting a certain amount of money over predetermined fixed periods of time like every 2 weeks or every month. I was really intrigued about this strategy, because supposedly it decreases your risk and makes you buy stocks when prices are really depressed.

I used VFINX (Vanguard S&P 500 index fund) total return data to test the performance of a lump sum investment versus dollar cost averaging. I assumed that an investor has $1200 to invest at the end of each January. They have two choices – invest it all at once at the end of January or spread their purchases over time. If they chose the second option, they would put $100 at the end of each month starting at the end of January. I ran the scenarios on monthly data from 1988-2007. The results really surprised me. Investors who purchased it all at once at the end of January achieved an average annual return of 11.28%. Investors who chose to dollar cost average achieved only a 6.22% annual return. That’s a 5% difference per year, every year. In addition, dollar cost averaging outperformed lump sum investing during only 3 years over the 20 year period – in 1994, 2001 and 2002. At the end of each year lump sum investors were $60.75 richer than dollar cost averagers. While it could be argued that the idle funds would have been earning interest I found that even if the cash was earning 6% annually over the past 20 years, lump sum investors would still be ahead by $26 per year on average.

If we actually started this experiment at the end of each December over our test period (1988-2007) instead of January, and checked at the end of the next December how much we have made the lump sum still outperforms dollar cost averaging by 5.50% annually. Of course if all you ever invested were the $1200, your total return over time would have been almost the same for the lump sum portfolio and the dollar cost averaged portfolio. If you put all $1200 in VFINX at the end of 1987 and reinvested your dividends, your stake would have been worth $ 10,840.91 by the end of 2007. If you decided to do dollar cost averaging with the $1200 by investing $100 per month starting in December 1987 and then you didn’t make any additional purchases but simply reinvested your dividends, the value of your portfolio would have been $ 10,021.24.

While it would be difficult for most investors to invest it all at once, since most of their investment contributions come through regular payroll deductions, it seems that although dollar cost averaging does prove beneficial during flat and down markets, it is inferior to a simple buy and hold approach. Academicians have shown that investors are pretty bad at timing the markets. Dollar cost averaging could be one of those timing strategies which contribute to the underperformance of a large number of the participants observed in those studies. Despite the fact that most investors have to dollar cost average, investing in the stock market even through an inferior entry strategy could produce far better returns over time than holding no stocks at all.

The spreadsheet can be accessed here: http://spreadsheets.google.com/pub?key=pOzbJBiI71k138vCpgQ50dw

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8 comments:

  1. That was a very interesting article. thanks for sharing it. I plan to include your article in my weekly carnival review next Friday.

    Best Wishes,
    D4L

    ReplyDelete
  2. Thanks a lot for the nice words dividend4life. I do hope to share my knowledge to my readers of this blog.

    You have a great weekend!

    ReplyDelete
  3. This is an interesting analysis. I Dollar Cost Average several mutual funds and always suspected this may not be the best approach. DCA definitely provides a discipline to save without you consciously deciding about it but it has is downside. For example I have been DCA'ing TAVIX and TAVX since 2003.It showed a very good XIRR (the Excel function to calculate accurate IRR's when you invest over a period of time)till market peak of July 2007. BEcause the market fell after that the XIRR has fallen significantly though I started almost 5 years ago.
    I am considering an alternative please see whether you can backtest this stratergy.
    I assume longterm return expectations of TAVIX is 12% every month I invest 100 dollars through systematic investing. Once a quarter, I check whether i received the 3% return, if the return is greater than 3% I do not do anything, if the return is less than 3% for the quarter, i put in extra dollars in the fund so that the total value equals principal+3%. This is kind of value averaging.

    ReplyDelete
  4. I think your analysis is flawed. The shortcomings of your DCA scheme can be entirely attributed to the fact that your money is, on average, invested later in the year.

    If you want to separate out the effect of DCA from the effect of earlier investment, have the investments occur, on average, at the same time. That is, if you are considering DCA to be an investment of $100 at the start of each month, compare that with $1200/year invested in the middle of June, and see how that performs.

    The results I would expect would be a slightly higher return from DCA, plus much lower volatility. However, all of this would be drowned out by the bigger picture, which is: invest your money as soon as possible.

    ReplyDelete
  5. Patrick,

    I disagree that the analysis is flawed. I am sure that if I looked at all the possible combinations using a simulation I could come up with an example where DCA outperforms the market. But would that be valuable to my readers?

    "The shortcomings of your DCA scheme can be entirely attributed to the fact that your money is, on average, invested later in the year."

    Actually the fictitious VFINX investor put equal sums of money at a fixed time every month. The end result of his purchases at year end assumed that the money should have been invested as soon as they were received.

    ReplyDelete
  6. Unfortunately, you loaded the dice on your analysis.

    I haven't checked yet, but I would imagine that if you started 4 months earlier (pre-1987 crash) you would've put in your lump sum at a 35% premium.

    ReplyDelete
  7. Thomas,

    Actually my data for VFINX using Yahoo finance didn't have a quote for December 31 ,1986.

    So the fact that I didn't include the 1987 crash was not intentional.

    ReplyDelete
  8. I've read through a few articles today on lump sum vs DCA. Let's say that you start out with zero savings and you are only able to save $100 a month. If you start DCAing, you'll be putting $100 a month in immediately and begin earning returns on your money. If you decide to wait 12 months to pile up $1,200 for a lump sum, you'd of course lose out on 12 months of DCA growth. DCA, in that scenario, would most likely be superior, as you'd likely have more than $1,200 after returns to to begin the next year's investing while the lump sum investment would have waited 12 months to contribute. Essentially, if you have the money on hand and you have the discipline to keep your spending down so you continue to have money on hand, then go lump sum. But given that most American's don't the cash on hand for it (and, more than likely, have debt instead), DCA is the best approach. When automated, DCA takes less discipline and is easier to include in a budget.

    ReplyDelete

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