Dollar-Cost Averaging is buying stocks in smaller, constant chunks of money over time, as opposed to buying all the stocks at once. By spreading stock purchases over time, one is less likely to buy stocks at their peak. Conversely, it would allow buying stocks at a lower price after a market's retrenchment.
There has been countless explanations, examples and analysis about dollar-cost averaging. Unfortunately, most, if not all of them are purely anecdotal, which can mislead investors on if dollar-cost averaging is an appropriate strategy for their portfolio, and if it is, the best way to apply the strategy. This is an attempt give readers a broader and more analytical answer.
How dollar-cost average works
It is worth noting that dollar-cost averaging is purely a lagging decision. If someone gets $500 to invest in the stock market every month, no more, no less, and uses them to buy the S&P 500 (SPY) as fast as he can, he's not really following a dollar-averaging "strategy". The dollar-averaging strategy is only applicable when one has, say, $100,000 to invest in the stock market right now, but decides to invest only a portion of the entire sum.
Here's an example of how dollar-cost averaging can lower risk. Let's compare investing $100,000 in SPY at $147.24 on September 14th, 2012, versus investing $25,000 per week for four consecutive weeks, and compare the overall performance of the fifth week.
In the first case, if we buy everything at once our cost per share is $147.24. With dollar-cost averaging, it's an average of the prices of the first four weeks: ($147.24 + $145.89 + $143.93 + $146.13 )/4 = $145.80. The stock price on the fifth week is $142.84, which means that by investing everything at once we would have lost almost $3,000, but we would have only lost $2,000 by using dollar-cost averaging.
Of course, this benefit only applies when the market goes down. When the market is bullish, keeping money in the bank is not the best option because statistically, stock market returns are higher than the returns earned in a typical savings account. This means that performance-wise, dollar-cost averaging can appear to be heresy.
Using Apple as an example
For a more detailed example on why this would appear to be heresy, let's compare the end value of a portfolio when buying $120,000 of Apple (AAPL) stocks at once (the 'Benchmark') versus investing $10,000 per month for 12 consecutive months (the 'Strategy'). First, starting January 2nd, 2008:
Clearly, spreading investments across multiple months helped in lowering the losses. While the Benchmark shows a loss of 56% in value, dollar-cost-averaging helped to decrease that loss to 'only' 39%.
But if we repeat the same experiment one year later, starting on January 7th, 2009, the results are quite different:
Here we could have more than double the portfolio value by investing all at once, while dollar-cost-averaging returned two times less.
Setting up a larger simulation
As we can see, the date at which one begins investing is crucially important to the outcome. These small examples do not help us to determine whether or not we should use the strategy. Therefore in order to get a reliable indication if dollar-cost-averaging is 'working' or not, we need to average the strategies performances over a large number of trials. We decide to go as far as January 1990, then continuously re-run the simulation by shifting its start by one week, with the following assumptions:
- Rather than running simulations for thousands of different stocks, we can use a large-scale aggregate of the stock market universe, such as the S&P500 SPY.
- Stock prices being fractal in nature, the time scale is of little importance. Therefore we can stick to deploying cash every month, over a period of one year.
- Dollar-cost averaging may incur additional trading costs, but we will neglect them.
- After the last amount of investment has been deployed, there is no need to continue the analysis since both portfolios will behave exactly the same.
Let's simulate investing $120,000 in SPY for 12 months, either in one lump sum (the 'Benchmark') or by investing $10,000 every month (the 'Strategy').
Here is the average of over thirteen hundreds simulations:
As we see, in pure returns, the dollar-averaging strategy is a loser. In the last 27 years, a 12-month investment in the S&P 500 provided a return of 8.77%, while using dollar-cost-averaging over the same period would have returned only 4.77%.
That being said, it's not all negative for the DCA method. During the same periods, the average maximum drawdown is 9.98% for the control portfolio, but only 5.87% for the DCA method.
If we factor the two by calculating the Martin Ratio (a measure of returns versus drawdowns, a higher number is better), we have 13.06 for investing-all-at-once, versus 13.50 for dollar-cost averaging. So, in short: DCA, not worth it.
How to make Dollar-Cost Averaging work
The reason for the lacklustre performance of dollar-cost averaging is the low returns provided by cash. The higher the returns we can generate on that cash before committing it to the stock market, the lower the opportunity costs.
Unfortunately, traditional short-term, low-risks assets such as savings accounts or T-Bills currently return close to nothing. We can try investing in Bonds, all at once, for instance with iShares Barclays Aggregate Bond Fund (AGG), then progressively cash out of bonds to buy stocks instead, at the same rate of $10,000 per month. Because AGG wasn't available in 1990, we have to start our simulations later, in January 2004:
Although returns are still not as high as with investing everything in stocks at once, the gap is smaller, at 5.8% average annual return versus 6.96%. Furthermore, substituting bonds for cash in the DCA portfolio still contributes to lower risks, and the average maximum drawdown still decreases significantly, from 10.61% to 5.99%.
We may try to do even better, by looking at assets that provide still higher returns. Between 2004 and now, investing in AGG for 12 months returned only 4.26%, or 63% less than stocks. Another issue is that bonds have become positively correlated with stocks in the last decade or so, making bonds a less attractive asset class for diversification. The ideal asset to exploit dollar-cost averaging's benefits would be to substitute the non-invested cash with an uncorrelated, low volatility asset with decent returns.
One solution is alternative lending. Notes issued by Internet-based origination platforms like Lending Club (LC) have, in the last 10 years or so, performed around 7% net per year, with a very low correlation with the stock market (see for instance this analysis I made a few years ago). Investing in Lending Club can be done is a very diversified way, by putting as little as $25 in a note. This diversification limits overall portfolio volatility. One constraint is that liquidity for notes is pretty poor. It may take up to 36 months (or even 60 for longer term loans) to get all the money back. But while liquidity for alternative lending is a disadvantage, the consistent and predictable cash flow from note payments can work in our favor for a dollar-cost averaging strategy.
However, this longer duration means we must tweak the previous dollar-cost-averaging simulations to invest $3,333.33 per month, for 36 consecutive months. With a 7% net annual return for our 'cash', the dollar-cost-averaging method now looks much more attractive:
While overall performance remains slightly lower, at 7.35%, the maximum drawdown is now only 1.12%, making it a much, much safer investment.
The stock market has historically been one of the best investments one can make. But the asset class's volatility and near-impossibility of timing the market means that the returns one receives for their investment can vary greatly depending on when one deploys their capital.
Dollar cost averaging is a solution to minimize downside volatility of the stock market. However, the opportunity cost for dollar-cost averaging is very high. Investors who use the strategy also significantly mute their portfolio's upside potential.
Dollar-cost-averaging can work in the investor's favor, but only when un-deployed cash can provide a significant return. Combining dollar-cost averaging with alternative lending supplements the drawbacks of each strategy, which can result in much lower overall portfolio risk for a given return.
Disclosure: I am/we are long SPY. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.