From time to time when I get my 401k statement, there is a small newsletter mixed in with my financial statement. It usually presents some very introductory information about retirement, investments, etc. In this issue one of the topics was dollar-cost averaging.
For those of you who don’t know, dollar cost averaging (DCA) is a strategy where you invest the same amount time after time. During the good times when shares are higher, you buy fewer shares. During the rough times when shares are lower, you buy more shares. This strategy prevents you from buying at the wrong time and over-spending or under-spending on your investments by “averaging” your price over time among these periodic investments.
Sound familiar? That’s exactly what you’re doing every paycheck when you invest in your 401k or similar plan.
So in theory, if you buy more shares during the bad times because they’re cheaper, then you should have a lot more shares than normal. AND when times get good again and prices go back up, you should have a lot more shares that increase in value.
Hey, wait! Didn’t we just live through one of the worst economic times in history? We sure did! The Great Recession is regarded as one of the worst financial periods to follow the Great Depression.
In fact, the entire period from the beginning of 2000 to the beginning of 2010 has been dubbed by the Financial World as “The Lost Decade” (not to be confused with the Lost Decade in Japan from 1990 to 2000). Why is it called this? Because basically all the capital gains achieved by stocks were erased. Let’s look at an example using the S&P 500 stock index:
• Start: January 3, 2000: S&P = 1394.46
• End: January 4, 2010: S&P = 1073.87. That’s a decrease of 23%!
• Say you had invested $120,000 back in the year 2000.
• Conventional investing wisdom teaches us that the stock market returns about 8%. So in that case, you should be looking at $266,357 by the start of 2010.
• Ouch! In reality, your portfolio is only worth $92,412 starting in 2010. That’s nowhere near what you thought after giving it 10 years to mature. Pathetic!!
I know I don’t want to lose 23% of my money! So my question is this:
• Would using dollar cost averaging have helped us make any better of a return during this period?
Like I mentioned earlier, we should have been buying shares for really cheap during 2008 – 2009, and wouldn’t that have “helped” our portfolios when the price returned to otherwise normal levels?
Plus, I’m guessing that very few of us ever rarely make one solid investment and do nothing for the next 10 years. So the theory of dollar cost averaging would be a more likely scenario.
So in the section above, we already calculated that a static investment of $120,000 back in 2000 in the S&P 500 stock index would have lost 6% by the time we caught up to 2010 (we’re going to ignore inflation and investment fees to keep things simple).
So now instead of making one giant investment, let’s pretend we invest $1,000 per month during that 10 year period in the same S&P 500 index. Based on what we know about dollar cost averaging, we should be buying random amounts of shares depending on how the market is doing at that snapshot in time. For simplicity, we’ll assign a cost of $0.01 to each point of the index (for example an index reading of 1000 would cost $10 per share).
So did we make some money?
Well, no. This time we lost 6.8% of our money, which is a major improvement from losing 23% in the prior situation.
You can download my calculations here: MyMoneyDesign_DCA_Lost Decade
So I bet I can guess what you’re thinking: This stinks! Why should I have invested my money at all? I would have been better off hiding it under the mattress?
And to that I say keep the following things in mind:
• That wasn’t the point of this example. This example was intended to test my theory that dollar cost averaging beats the odds of a static investment, not demonstrate the benefits of investing in an index fund. We only chose the Lost Decade because of its recent significance. You should know that if we had picked a different 10 year time period, we probably would have had positive returns rather than a negative one. For example, between 2002-2012 the market returned +16.12%! Remember that statistics is all about how you present the data!
• 10 years is a relatively short time period when it comes to investing. If you look at investments over a very broad range, you’ll see that the market did indeed return a historical average of 8%.
• The Great Recession was pretty bad. This past decade will definitely go down in history as one of the top five worst economic periods of modern times. While that probably doesn’t help the current situation, an optimistic person would look towards the future hoping that history will not repeat this cycle for a long time to come.
And finally my favorite point:
• Asset Allocation. Notice this example is just for the S&P 500 (large cap stocks). Would we have broke even or possibly made money during this decade if we had also invested in bonds? Click here to read Part 2 of this series where we’ll continue this discussion and crunch the numbers to find out!
Readers: Do you believe in dollar cost averaging, or do you have a different strategy for spreading your investment risk? What was your take on the Lost Decade? Were you one of the lucky few who actually made money? If so, how did you do it? Please feel free to share!
Photo Credit: Microsoft Clip Art