The idea behind dollar cost averaging is simple. Every month invest a set amount of money into the stock market. When the market is high, you’ll be able to afford fewer shares and when it’s low you’ll be able to buy more shares at a lower price.
Over time, the stock market moves up, your average entry price stays relatively low, and you begin to accumulate a substantial portfolio.
Many investment professionals recommend dollar cost averaging because it is a robust way to invest a salary. Even Warren Buffets mentor Benjamin Graham was a fan of DCA and he discusses it in his classic book The Intelligent Investor.
I like to think of dollar cost averaging as not just as a way to invest money but also as a type of enforced savings.
Unlike lump sum investing or even short-term trading, the returns from dollar cost averaging are not just a product of what the market provides but rather, how much you can save and put in each month.
The more you save, the more you can invest and the bigger your pot will become. And dollar cost averaging also has tax advantages because there is no need to need to sell positions.
What Can You Expect From Dollar Cost Averaging?
From my analysis of US stock data, the typical yearly return from dollar cost averaging (including dividends) seems to be around seven or eight percent – usually a little bit lower than the return from a buy and hold approach.
That might not sound like much but this is more or less the reality of stock market investing over long time horizons. At least you’re doing better than a savings account, bonds or real estate.
The following equity curve recreates the dollar cost averaging approach. The results shows the performance of investing $1000 each month into SPY, the S&P 500 ETF between 5/2008 – 5/2018:
You can see that with a monthly investment of $1,000 we end up with an end portfolio value of almost quarter of a million.
The total amount invested over 10 years is $120,000 (12 months x 10), the net profit is $121,550 and the annualized return is thus 7.24%.
Beating Buy And Hold
Over the years I’ve become quite obsessed with DCA and tried many ways to try and improve on this seven or eight percent. Unfortunately I haven’t found much that beats this threshold (that is suitably robust enough to recommend anyway).
On the plus side, seven or eight percent is much better than what a typical savings account provides and compares favorably with the long term average of US stock returns.
Also, as I pointed out earlier, the end result is not only a function of the market but how much you can put in, and you have a lot of control over that.
For example, if you invested $1000 into SPY (the popular S&P 500 ETF) every month between May 2008 and May 2018 your portfolio today (as we saw above) would be worth $241,550.
In other words, you would have invested a total of $120,000 over 10 years and doubled your money.
The table below shows some more examples:
If you had a slightly better job and were able to invest $2000 a month your total pot would now be worth just shy of half a million ($483,100).
Ratchet that up to $5000 a month and your portfolio would be sitting at $1,207,749 after ten years.
Comparisons With Lump Sum Investing
Read any article about dollar cost averaging and you usually find some arguments explaining why DCA is not as good as buy and hold.
It’s true. You can see from the table above that buy and hold does result in a better return.
We got 8.94% annualized for buy and hold versus 7.24% annualized for DCA.
However, this argument is flawed because buy and hold assumes you have money to start with.
The truth is that most people are not sitting on a lump sum of $120,000 so most will not be able to benefit from buy and hold investing.
But, a lot of people are capable of saving $1000 a month and by utilizing a regular investing approach they can end up with a result that is nearly as good as buy and hold.
Trying To Improve DCA Investing
As I mentioned above I have thought of several ways to try and improve dollar cost averaging over the years although not all of them have been successful.
To give you an idea, here are some of the things I’ve tried:
- Using various different ETFs
- Using a leveraged ETF (good return for some but higher risk)
- Buying individual stocks at random
- Picking only low priced stocks
- Buying the biggest winners/biggest loser stocks
- Picking the lowest/highest RSI stocks
As an example, the following strategy buys the four biggest losers in the S&P 500 from the previous month. So every month we buy the four biggest losers with $250 each. We never sell, we just keep on picking up new stocks every month.
(If you are interested, here is the Amibroker code to simulate this).
Over time we accumulate a portfolio of almost 500 stocks in this way, all bought at what you would consider ‘low’ prices.
However, you will see that our average return is not any better over the ten years than if we had just stuck to the simple SPY ETF. We’ve scored an annualized return of only 7.16% before commissions with this strategy:
By all means, it is a good idea to experiment and come up with new ideas for improving DCA.
But at the end of the day it seems that most investors are better off focusing on earning and saving more investment capital rather than looking for clever ways to improve on the basic DCA technique.
Simulation and charts in this article from Amibroker using data from Norgate Premium Data.
Stocks were selected from S&P 500 universe with a minimum turnover of $500,000. Includes delisted stocks. No commissions applied.
Thank You For Reading
Joe Marwood is an independent trader and the founder of Decoding Markets. He worked as a professional futures trader and has a passion for investing and building mechanical trading strategies. If you are interested in more quantitative trading strategies, investing ideas and tutorials make sure to check out our program Marwood Research.
This post expresses the opinions of the writer and is for information or entertainment purposes only. It is not a recommendation or personalised investment advice. Joe Marwood is not a registered financial advisor or certified analyst. The reader agrees to assume all risk resulting from the application of any of the information provided. Past performance, historical or simulated results are not a reliable indicator of future returns and may not account for real world settings. Financial trading is full of risk and margin trading can lead to financial losses totalling more than what is in your investment account. We take care to present accurate analysis but mistakes in backtesting and presenting of analysis regularly occur. Please read the Full disclaimer.
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