Dollar cost averaging (DCA) is a fundamental investment strategy. It is implemented by a regular savings plan (RSP) which makes it easy to allocate a fixed amount of money every month to a diversified portfolio.
Understandably, the benefits of DCA have been extolled by experts and financial institutions alike. After all, what's not to like about disciplined investing, without the destructive effects of our emotions, where we get to take advantage of the inevitable short term market price volatility - buy more units of blue chips when the markets swing downwards and yet are protected because we buy fewer units during price spikes.
Besides the advantage of DCA mentioned above, because we are investing over a period of many years rather than one big lump sum at the beginning, the average dollar invested should have a higher compounding ann ual growth rate (CAGR).
When we google about DCA, one does find a couple of critics as well. But I tend to dismiss them if they use very short term data - like investing in a fund tracking the US Dow Jones Industrial Average (DJIA) over just 12 months.
My first hand research
There is nothing like putting a theory to the test with real life data. I found a spreadsheet from Standard & Poor's (S&P) that gave me the month to month growth of the S&P 500 total returns index from 1988-2009.
This meant I could test the performance of lump sum versus DCA investment strategies over a period of 22 years. This was a good testing ground because it included 3 major bear market phases and 3 bull runs.
Total returns means returns of a portfolio with all dividends reinvested back into the portfolio. This is the holistic measure of performance.
For the test, I compared a one time investment of $100,000 in January 1988 versus $1,000 invested every month from that same point in time. The investment amounts carry less significance because our aim was to measure the CAGR for each dollar.
Startling results
The $100,000 became $660,740 by the end of October 2009. That represented a gain of 9.07% per annum which was largely expected. In fact, the longer term CAGR of the S&P 500 total returns is close to 10% per annum.
What shocked me was the CAGR of the DCA strategy. The total investment of $261,000 became $565,000 representing a gain of 6.43% per annum! And I was expecting a return of well over 10% per annum. What could have happened?
http://www.samwadia.com/dollar-cost-averaging-test
Likely Explanation
Dollar cost averaging does work. After all, it did net positive returns for the investor over the roller coaster years of the stock market.
DCA is best when applied to investments in volatile, long term growth markets such as those of emerging countries as well as some commodities. The S&P 500 was simply not as volatile or fast growing - typical of a mature economy.
And it is still the best approach for people who do not have large sums of money sitting around, but rather the majority who save a little every month.
