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John McMillen | Portfolio Manager

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Does Dollar Cost Averaging Makes Sense?

August 2010

The recent market volatility has created anxiety for many investors who have excess cash to invest in the equity markets. With painful memories of the 2008-09 downturn still fresh, many investors are, understandably, hesitant to put a significant amount of money into stocks all at once.

Faced with high levels of volatility and economic uncertainty, should one fully invest new money today or dollar-cost average (i.e., invest a portion of the total amount to be invested at set time periods) in an effort to reduce timing risk? Interestingly, looking at the historical data, it seems the correct choice to maximize one’s wealth is to invest all at once - today. Let’s examine why.

The table below shows the monthly returns of the S&P 500 over the past 84 years:

Monthly: 01/1927 - 06/2010

No. of Periods

% of Time Period

Average Monthly Return

S&P 500 Index: Up

619

61.78%

3.95%

S&P 500 Index: Down

383

38.22%

-3.96%

S&P 500 Index

1002

100.00%

0.92%

This shows the S&P has generated a positive monthly return 61.78% of the time. Because short-term market prices are a random walk (meaning they are unpredictable), investors who dollar-cost average on a monthly basis have a higher probability of averaging into a higher market, thereby increasing the cost of their investment.

Moreover, spreading the dollar-cost average over even greater time periods, such as quarters or years, will only increase this probability. Because the market has a positive expected monthly return, the longer the time period, the more likely this expected return will materialize into actual positive returns - returns the investor will subsequently miss because he is sitting in cash:

S&P Index: 01/1927 - 06/2010

No. of Periods

No. of Up Periods

No. of Down Periods

% Up

Monthly

1014

619

383

61.78%

Quarterly

334

225

109

67.37%

Yearly

83

62

21

74.00%

Some investors believe that market losses are “clumpy” (meaning losses tend to be followed by more losses and one should therefore postpone investing until volatility subsides), but history has shown this, too, is a low-probability event:

Occurrences of Back to Back Losses

 

 

 

S&P Index: 01/1927 - 06/2010

Occurrences

No. of Periods

% of Periods

Monthly

154

1002

15.47%

Quarterly

45

334

13.47%

Yearly

6

83

7.23%

As you can see, even the shortest time periods – monthly – have only seen about a 15% occurrence of consecutive negative returns. When we look at yearly returns, that occurrence drops by half; in other words, history shows that 93% of the time a down year is NOT followed by another down year.

So, while many investors believe dollar-cost averaging minimizes timing risk, there is also clearly a cost to waiting to invest. Past history gives us a clue about that expected cost, which can be measured as the difference between the S&P 500 return and the one-month Treasury bill:

Monthly: 01/1927 - 06/2010

No. of Periods

Annualized Compound Return

Average Return

S&P 500 Index

1002

9.63%

0.92%

One-Month US Treasury Bills

1002

3.64%

0.30%

Difference +/-

 

6.02%

0.63%

To be clear, over short investment horizons either strategy may produce vastly different levels of wealth; however, those with a short investment horizon may want to revisit whether equity investing is even appropriate. 

For individuals with suitably long investment horizons, the data supporting a lower expected return by dollar-cost averaging is consistent with Modern Portfolio Theory. Cash investors assume less market risk and therefore have a much lower expected return than equity investors. Any strategy that extends the length of time an investor holds cash, such as dollar-cost averaging, has a much higher probability of costing that investor real dollars compared to what they would have earned had they invested all at once.

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