I’ve recently read a number of articles badmouthing a dollar-cost averaging investment strategy (i.e., investing a certain amount of money in stocks at regular intervals). Consider, for example, this article in USA Today.
The author mentions that if one had invested $100 per month in the Vanguard 500 Index Fund over the past decade, one would currently own shares worth $15,437, a gain of $3,437, or 31.3%, over the total invested amount of $12,000. The author contrasts this with an investment of $12,000 made exactly 10 years ago which would be worth about $26,640, a gain of 122%. The author claims that the disparity between the investor’s actual return of 31.3% and the total 122% return of the S&P 500 over the past 10 years shows that dollar-cost averaging doesn’t always work.
I wholeheartedly disagree with the author’s conclusion. First, the hypothetical investor discussed in the market desires to invest money periodically in the market and probably would not have the entire $12,000 to invest all at one time 10 years ago.
Second, because the dollar-cost averaged shares are purchased over a period of 10 years, the average share of stock would have been purchased only 5 years ago (halfway through the time period), so it’s not really fair to compare that with money invested a full 10 years ago. If the author wanted to make a fair comparison, he would compare the dollar-cost averaged shares purchased versus a lump-sum purchase make exactly 5 years ago, so that both investments have the same average investment time period. Seeing as how the stocks experienced a strong decline in 2001 and 2002, I would bet that the dollar-cost averaged shares would come out ahead in that comparison (with less risk!).
Third, one of the great benefits of dollar-cost averaging is that it spreads risk out over time. That is, instead of trying to guess where the “bottom” of the market is and invest all of one’s money at that time, the risk of over-paying for the stock can be spread out over an extended period of time. Several theories of equity valuation acknowledge that short-term inefficiencies exist in the market and that stocks often trade at a premium (or discount) to their true intrinsic value. However, there are few investors, if any, who have the ability to accurately determine the true intrinsic value of stocks at a particular time. By spreading the money to be invested in stocks over a long time period, the investor reduces his chances of overpaying, on average, for the stocks.
Fourth, by dollar-cost averaging with index funds the investor can avoid having to spend a lot of time/money researching stocks to determine which to purchase. Instead, the investor can simply determine the long-term historical returns/trends for stocks and invest accordingly. For example, I invest according to my Hypothetical Model Portfolio and expect it perform well over time.