Friday, July 14, 2006

Attacks on Dollar-Cost Averaging Investment Strategies Are Unjustified

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.


makingourway said...


A few quick points:

The USA today article's criticism suffers from survivorship bias. What happened if the investment was made at a different date - perhaps in the 1970s when the S&P 500 had vastly different performance data? The point and shoot investor would be stuck with the performance of the market at one specific point in time. He has no way of knowing if he's at a market high or low. He may know how it's performed in the past, but future returns over periods less than 20 years are more random than predictable (Has W. Bernstein brainwashed me?).
The bottom line being he could have picked a bad moment to plunge his money in.
Dollar cost averaging was specifically designed to protected against time sensitivity, letting the investor leverage the ups and downs to maximize investments.

Here's a question for Jim and readers - what do you think of Dollar Value Investing. Actually it reminds me alot of a defined benefit plan - the core concept is that you you purchase enough of your target investment to have your portfolio achieve a target value each month. If the market drops you invest more. If the market climbs, you invest less or even sell. The approach enforces allocation principles and investment discipline.

Have a wonderful day,

Jim said...

Makingourway, I don't think that "survivorhsip bias" has anything to do with what you wrote. However, your point about the time at which the 10-year investment is initially made is well-taken. My biggest problem with the article is that the author completely disrgards the benefits of risk reduction that come with spreading investments over time.

I had never heard of "Dollar Value Investing" until I read that article. I completely disagree with that as a coherent investment strategy.

The author of the USA Today article wrote that accoridng to a Dollar Value Investing strategy, people adjust the amount of mney they invest so that the total portfolio value increases by a set amount each month (e.g., $1,000 per month). As an example, one might invest $950 when the value of the portfolio has increased by $50 on its own, or $1100 when the value of the portfolio has decreased by $100 on its own.

In my opinion, Dollar Value Invesment only makes sense for people just starting their investing who are increasing their total investment portfolio by a large percentage each month. If I start out with no money in the market and then invest $1000 per month, I could easily follow the strategy because if the market falls 10% when I have $1000 invested, I would only need to invest an extra $100 in the second month to bring the total up to $2000 by the second month. However, if I have a prtfolio with $100,000 in it and I want it to increase by $1000 per month, a 10% drop would take it down to $90,000, and I would need to invest $11,000 in the subsequent month. That's not a good strategy to follow. Imagine how much you would have had to invest between 2000 and 2002 if you had a large portfolio in 2000 and followed this strategy.

I think it is much simpler to simply follow a Dollar Cost Averaging strategy.

Sometimes I read articles in USA Today or Money Magazine and then wonder if the author completely understood what he wrote. Money Magazine is so bad and so dumbed-down that I stopped reading it a number of years ago.

taxxcpa said...

Generally, if you have $12,000 you would almost certainly be better off investing it all at once, instead of dribbling it out at $ 100 per month. If you only have $100 available now plus $100 per month in future months, it is better to invest it as it comes available rather than to wait until you accumulate $12,000 (assuming no commissions).

My approach is to invest heavily in stock-related ETFs when a bear market begins to recover, then lighten up after an extended bull market and switch to bond-related ETFs. I keep holding some stocks after an extended rise, since who knows when it will stop?

Currently, I have 20% stocks, 20% cash and 60% bonds and CDs.