Dollar Cost Averaging is the practice of investing a set amount of money each period over time, rather than making lumpy one-time investments. Employees who contribute a set amount of their paycheck to their 401k plan each month are essentially dollar cost averaging. There are a lot of advocates for dollar cost averaging in the investment community who claim that over time it will radically reduce your downside risk by forcing you to buy more shares when the market is down, and less shares when the market is up. It programmatically helps people to avoid emotional trading decisions that can often times lead to big losses in the market.
In general I’m a big fan of dollar cost averaging, but I was curious to see how well this practice really did protect people’s capital investment during the big downturns of 2002 and 2009. In testing this I downloaded quarterly returns for the S&P 500 total return index (inclusive of dividends) over the past 15 years and mapped out staggered returns under a dollar cost averaging strategy over 3, 5, 7, and 10 year periods. Here is what I found out:
3 Year Hold: Over 13 different possible 3-year hold periods in the last 15 years (i.e. 1999-2001, 2000-2002, 2001-2003, etc.), 4 of those periods resulted in cumulative losses ranging from 2% to 28%: 1999-2001 (9% loss), 2000-2002 (22% loss), 2006-2008 (28% loss), and 2007-2009 (2% loss).
5 Year Hold: Over 11 different possible 5-year hold periods in the last 15 years, only 2 of those periods resulted in cumulative losses ranging from 2% to 23%: 2004-2008 (23% loss) and 2005-2009 (2% loss).
7 Year Hold: Over 9 different possible 7-year hold periods in the last 15 years, only 1 period (2002-2008, 15% loss) resulted in a cumulative loss. Similarly, there was only one 10-year hold period over the past 15 years that resulted in a cumulative loss (1999-2008, 16% loss).
Not surprisingly, the effectiveness of dollar cost averaging depends on the length of your holding period. Overall I’m very impressed by how well the strategy of dollar-cost averaging would have protected investor’s capital during significant downturns. If you had been willing to commit to this strategy for a period of 7 years, there would have been only 1 unlucky starting point over the past 15 years (2002-2008, 15% loss) in which you would have actually lost a portion of your capital over the entire holding period. The other 7-year periods would have resulted in cumulative gains ranging from 6%- 59% gains.
It’s not riskless, but I think dollar cost averaging is a great strategy for investors, particularly individuals who are wary of wild market swings and are willing to take a patient, long-term approach to building their nest egg. Message me if you’d like to see my excel back-up and further data on this- I’m happy to share.