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!
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3) A Strategy for Maxing Out Your Retirement Savings
Photo Credit: Microsoft Clip Art
Julie @ Freedom 48 says
I think dollar cost averaging is an excellent way to mitigate the losses. Take advantage of the low times – which will help you gain even more later on.
Unfortunately we don’t use that method since I we tend to save up a bit in our savings account and then buy investments in $5,000 lump sums.
May I ask why do you wait to buy them up in $5,000 sums? Is it because you buy individual stocks or ETFs and want to cut down your commission fees? Or do you buy mutual funds? I also use to fund my IRA in large lump sums (with mutual funds) when I would get my annual tax refund or profit sharing check. But not too long ago, I decided to change my budgeting strategy to where my IRA would be funded by equal monthly deductions from my checking account. It was trick to learning to live on less income!
Emily @ evolvingPF says
We DCA but not necessarily because of the theory. We simply don’t have lump sums to invest and prefer to save a little each month rather than waiting to get into the market.
I’m the same way with investing in my IRA. I regularly buy mutual fund shares each month. That way I’m never really “timing” the market.
Invest It Wisely says
Yes, I like dollar cost averaging but I also like dumping when the markets have an abrupt turn. If you had some cash lying around in late 2008 or in 2009, then why not?
Also, dollar cost averaging works because you invest as you receive. What’s the alternative? Just letting the money accumulate in the bank and timing? Then you’re just guessing. I agree when dumping when the markets take a downturn but that money you put in should be part of your normal strategy, as otherwise you may be missing out on too many of the gains during the good years.
Absolutely. If nothing else, investing should be done at regular intervals rather than waiting for “the perfect moment” – because you’re never going to find one.
Great read. For all the reasons you’ve stated, I honestly don’t believe in dollar cost averaging. In the last decade, DCA has not made any money. I’ve written several articles on how I make over 30% by investing short-term(1 to 6 weeks). I only invest in large cap stocks with relative safety. And it works.
I agree that to have been saved from the Lost Decade, you would have needed a more advanced strategy than simply using index funds or DCA. However, the post was meant to demonstrate that DCA (-7%) was a better hedge than having made a single static investment back in 2000 (-23% return).
The inspiration for this post came from seeing media articles and academics where people showed the S&P 500 as having been a terrible investment by comparing the index values between 2000 and 2010. To the common reader, this is misleading. Few of us ever really invest in this way. The retirement contributions that come out of our paychecks every two weeks is a more plausible scenario and I wanted to find out just how powerful those purchases during 2008-2010 made on our portfolio. Unfortunately, it was not enough to pull from red to black.
I am very glad for your fortune with short-term investing. And I do not mean to sound like an advocate for index fund investing only. But do you feel as though this momentum with short term results is repeatable over the long haul?
Christopher @ This That and The MBA says
I think dollar cost averaging is great when the momentum of the stock is downward. When the stocks are moving up slowly, I try to toss in a bunch of money to catch the uptick but not raise the overall cost per unit too much.
Christopher: This is an interesting strategy you purposed. I just worked out an example on the side to make sure I understand you correctly. By doing what you suggest, you’re simply buying up more shares (while the price is still relatively low) to keep the average dollar per share cost down, right? This appears to only work until prices have returned to “normal”.
Christopher @ This That and The MBA says
Exactly….use the DCA as the stock is on the decline to lower overall individual share price of the portfolio. And as the stock price climbs pick price points and drop larger sums of money in rather than a continual flow of money whether biweekly or monthly. If it looks like it is peaking I do not want to keep pumping money into this stock as it is only going to raise the overall price that I paid for it closer to what the current price is. And if it is at a 52 week max or some other max, I would suggest staying away from it and investing elsewhere.
Thanks for explaining your strategy further. I’m noticing a lot of the comments discussing DCA in regards to individual stocks. I was actually thinking more along the lines of 401k plans and mutual funds when I wrote this, but there is no reason the same strategy couldn’t work for common stocks. There are only two cons I can think of with this strategy when I compare stock buying to mutual funds. The first being commission fees to continually purchase new shares. The second being that mutual funds fluctuate at a slower rate than individual stocks, so your chances of spotting an upward or downward trend should be easier. Have you experienced one in favor of the other?
Alik Levin says
Just want to show my appreciation to what you have posted here. I am learning all that stuff in your posts and it makes me feel dizzy 😉
On a serious note, it helps me get out of self denial I put myself regarding this area.
Hopefully it also helps you to be richer someday! Thank you very much for the appreciation!
Just curious… did you consider dividends in your example? Dividends may actually be enough to erase losses.
DCA definitely works as a way to make sure you are disciplined enough to keep buying on the way down without trying to time the market. However, if you flip the fact pattern and take a period with large gains, your DCA methodology will return less. It is a very effective hedge in that it protects you from large swings in price (both up and down). It doesn’t always work to increase your return, though.
Thanks for asking. No, I did not consider dividends or inflation in this example. It was intended to just be a simple comparison between how much the media claims you’ve lost during the Lost Decade versus how much you’ve actually lost by using your periodic investments.
That is an excellent point. Yes, during the good times, DCA will not allow you to capture the extreme highs that you could potentially capture with a few static investments. But, like all investing, no one knows when those good times are going to be. Thus people should think of DCA more as a safety mechanism rather than a get rich strategy.