Dollar-Cost Averaging investment strategy

Dollar-cost averaging is an investment strategy that tries to reduce the risk of investing (volatility) by investing a fixed amount of money over a specific duration of time. The time frame is typically long-term. If the time frame is smaller it tends towards lump sum investing. It goes by few other names e.g. Unit cost averaging.

To illustrate the benefits of dollar-cost averaging I wanted to pick a real life example. The graph below shows the variation of Vanguard S&P 500 index fund (VFINX) from 04/25/2008 to 4/16/2010. I chose this particular time frame as it includes the lowest value of the fund. In addition, the fund value on beginning and end date are almost same. So, 10,000$ invested on 04/25/2008 would be worth slightly less on 04/16/2010.

Obviously the best point to buy would have been on 3/6/2009 at $63.26. Selling point then would be at $110.09. The return would have been 74.03%. That is the best case scenario. What if we had invested our money and the market kept going down? Unfortunately, we do not have the power of hindsight to help us in real situations. How than can we get a fair return in a volatile market? The answer to that question is dollar-cost averaging.

Let’s say we had $10,000 to invest on 04/25/2008. Instead of investing as a lump sum, money is distributed equally across a time frame. In the above time frame there are 104 weeks (2 years). If $96.15385 is invested every week then at the end of 2 years $10,000.00 would have been invested. The final value of investments on 4/16/2010 would have been $11,664.23 (16.642% returns on investment). This by no means is spectacular compared to the 75% return above. However, we have successfully navigated a volatile stock market and ended up with 17% returns. Not too shabby.

DRIP provides a natural way to dollar-cost average. Here is a table showing the dividends payed out by Vanguard S&P 500 index fund (VFINX) between 4/25/2008 and 4/16/2010:

Now, assuming we invested $10,000.0 on 4/25/2008. We would have 77.65 units of VFINX (at $128.78 a unit). On 4/16/2010 we would have 81.36 units (including 3.70 units from dividend reinvestment). The value of 81.36 units would be $8792.055 (at $108.07 per unit). This would still be a loss (12.07%) compared to our $10,000 initial investment. This loss is still better than the 16.08% loss without dividend reinvestment. In effect the dividend reinvestment (dollar-cost averaging) has led to additional gains of about 4%. This 4% is close to twice the yield of VFINX.

The immediate question than is what is a good time frame for dollar-cost averaging? Some people tend to dollar-cost average weekly to exploit the volatility of the market. I looked at three possible time frames to dollar-cost average i.e. Biweekly, Monthly and Yearly. Typical paychecks are biweekly or monthly. The graph shows the growth of $100,000 invested over a 15 year time frame. Investment is in Vanguard S&P 500 index fund. In the case of bi-weekly dollar-cost averaging the $100,000 is invested uniformly across the span of 15 years on a biweekly basis. A similar strategy is then adopted for monthly and yearly scenarios.

Biweekly and monthly returns are comparable. They do have minor fluctuations. So, depending on what we consider as the end point one or other might be better. On the other hand yearly dollar-cost averaged returns are much better. This is kind of expected as we are in the middle of a significant bull market i.e. Money invested earlier the better.

This brings us to an alternative strategy i.e. lump sum investing. If we had invested the $10,000 on 3/6/2009 at $63.26 our returns would have been a stellar 75%. As mentioned earlier, this strategy works the best in a bull market.

If we had invested with our dollar-cost averaging strategy we would have invested $169.49 per week over 59 weeks. This would have given us a return of 19.244%. Not a bad return, but nothing compared to the 75% return we got with lump sum investing.

The final decision is based on risk tolerance. Lump sum investing maximizes returns and risk. Dollar-cost averaging spreads the risk of investing and corresponds to a reduced return. In a bull market lump sum investing is a sound strategy as it gets you invested immediately. In a volatile market dollar-cost averaging is a better strategy.

If you have a million dollars by all means invest it immediately. Just be cautious and diversify your investments. Dollar-cost averaging a million dollars would provide sub optimal returns. A decision to dollar-cost average a million dollars is mostly emotional.

In my opinion the best investment strategy for someone in accumulation phase with a regular pay check should be lump sum investing coupled with dollar-cost averaging. Lump sum does not always mean a significant chunk of money. It is a relative term. For e.g. Investing 50% of ones paycheck can be considered a lump sum investment. Repeating this for every pay check makes it dollar-cost averaged. Although we think we are using dollar-cost averaging strategy we are actually taking a hybrid approach. This approach might be the most effective.

One additional consideration is the brokerage fees for transactions. In my article, I assumed zero brokerage fees. Vanguard funds trade for free with a vanguard brokerage account. Services like Robinhood provide zero dollar trades for stocks and ETFs. Nevertheless, brokerage fees can have a negative impact on the overall dollar-cost averaging strategy.

Source:
Historical data was obtained from Google finance.
Dividend information is from Vanguard.com