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Myths and Fallacies of Dollar Cost Averaging
Dollar Cost Averaging is a method of investing that spreads out an investment into equal monetary amounts which are then regularly and periodically invested over specific time periods. An example is to divide $12,000 up and to invest $1000 each month for 12 months.
Note that we don't define regular investing (say monthly from your salary) as dollar cost averaging (DCA). DCA is when you have a choice - lump sum all at once or spreading it out.
DCA is promoted as giving two advantages: (1) it reduces the timing risk of entering the market by preventing you from investing all your money just before a crash and (2) it increases your returns because you buy into the market at a lower average price. This results from the fact that in the normal ups and down of the market you get more shares when the price is down and fewer shares when the price is up.
A typical quote for (1) goes "reduces the risk of investing just before markets drop by spreading the investment out over the year."
A typical quote for (2) goes "usually giving a better return than paying in a larger amount say once a year."
Unfortunately neither of these statements is true.
That (1) is false is easy to show: market crashes can come at any time. It doesn't matter whether you invest in one lump or over 12 smaller portions the day after you are 100% invested is just as likely as any other day to have a crash. Unless you can predict crashes there is no way to mitigate them by timing your entry to the market.
(2) is easy to show to be false too. On average the market goes up. So by delaying your entry to the market by spreading out your investments you, on average, increase the price you pay. So on average dollar cost averaging (DCA) reduces your return.
The quote "the more the price changes, the more you gain from dollar cost averaging" should be more correctly worded "the more the price goes down, the more you gain from dollar cost averaging."
The only time it increases your return is when you invest during a bear market. But if you are clever enough to predict that a bear market is coming up then you should wait till the bear has ended before making any investment.
On average there is a bear market 25% of the time and it is difficult to predict when bears will occur. So DCA will cost you some return the other 75% of the time.
Because the market usually goes up the best way to invest your money is all of it as soon as possible. For many people with regular income this will mean regular payments into the investment. This isn't DCA. DCA is when you have a lump sum and spread it out.
We illustrate below a simple demonstration using the S&P 500. If you would like a more extensive discussion of the DCA fantasy (such as transaction costs and human shortcomings) Brent Sheather's article Popular safe strategy comes at a cost is a good read.
Another claim made for DCA is that it (3) "smoothes out the volatility" and various other claims about risk reduction. Of course it does. We don't dispute this fact. The risk reduction comes about because you are only partially in the market - part of your investment stays in cash. If you like that then go for the whole hog and stay 100% in cash.
An Example Using the S&P 500
Regardless of whether you believe the above arguments here is a concrete example using the S&P 500 (backfilled to 1800 using numbers from Global Financial Data).
For every month since 1800 we calculate our return over the next year from both (i) investing a lump sum or (2) splitting that lump sum into 12 equal monthly payments and making them over the next year. This gives us two return figures and we colour the S&P 500 price for that month red if the DCA return was higher than the lump sum return or green if lower. (We use log prices to make the charts more readable). When we use DCA the investments that have not yet been put into the market are assumed to earn zero interest. We will change that later.
This first chart shows the whole period from 1800 onwards.
This second chart shows more recent history - the period from about 1970 onwards.
We see clearly that most of the time lump sum investing beats dollar cost averaging. In fact, since 1800 DCA only won 27% of the months. And since 1970 only 26% (and since 2000 the percentage rises to 37% due to the two bear markets in that decade).
A legitimate concern is that we assumed that our non-invested portions earn no return. This is unreasonable. So we also did the calculations assuming a 4% annualised return. We don't show those charts here because they look virtually the same as the ones above. We do note that DCA beats lump sum investing more often - the three percentages above respectively rise to 37%, 31%, and 42%. So you are still better off using lump sum investing which makes higher returns two thirds of the time.
More Volatile Investments - Better?
A more interesting claim for dollar cost averaging is this one: "regular investors will tend to do better over the long term if they put their money into more volatile investments."
Is this true? All other things being equal are more volatile investments better? We can easily test this out with simulations. We have to use simulations because there are few examples of real life funds with identical returns and differing volatilities.
The S&P 500 data above have a mean return of 8.52% per annum and a standard deviation of 16.7%. So let's simulate a whole lot of price series with all have a mean return of 8.52% but with differing standard deviations and let's invest $1 each month into the price series.
The next chart shows a couple of examples of the simulated prices. The green line is the S&P 500 as above. The blue line is a simulation with 0.25 times the volatility of the S&P 500 and the purple line 4 times the volatility.
Now we do the simulations many times with differing multiples of the S&P 500 volatility and plot the final return using DCA versus volatility.
Note that we have 2565 months so invest 2565 dollars altogether. In the S&P 500 we get a final total value of $5,977,271,217.
The results of the simulations are below. The magenta line is the mean of the final amounts for each level of volatility.
We see that, indeed, as volatility increases the final return on average increases. The increase is not guaranteed, however. The more volatile investments can have lower returns. And this is even after 200 years of investments. So a long time period does not help.
So it appears that regular savers can relish a bit of volatility in their investments.
Note that this is not an argument for dollar cost averaging. We have shown that DCA generally reduces your returns over lump sum investing. This S&P 500 simulation study did not compare DCA with lump sum investing. It just compared DCA on different volatility investments. Even if you use DCA on a very volatile investment it will still do worse than lump sum investing.
If instead of investing $2565 monthly since 1800 we had invested the whole lot as a lump sum we would have had $99,988,880,689. That well and truly beats the DCA amount of $5,977,271,217.
You may like to read a continuation of this discussion in regard to leveraged ETFs here.
Conclusion
Dollar cost investing is not as good as lump sum investing but if you are going to use DCA then a more volatile investment is likely to produce a higher final value than a lower volatility product that has the same return.
Note: all quotes are taken from New Zealand media and can be found online.