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:

Relevant Articles:

- Dividend Aristocrats List for 2009
- Dividend Aristocrats
- Best Dividends Stocks for the Long Run
- Best High Yield Dividend Stocks for 2009
- Best CD Rates

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