Dollar cost averaging is a long-standing method of investing that helps investors reduce risk by building up their portfolio’s gradually, rather than investing a lump sum all at once. However, what is the reality of the returns of using either method, and when or how should they be used?
What exactly is dollar cost averaging?
Dollar (or Pound) cost averaging (DCA), is a technique for establishing investments over an extended period of time. It’s main principal is to invest equal amounts of money into the market at defined intervals, such as weekly, monthly, quarterly or yearly. By doing this it aims to ‘average out’ market price volatility and give the investor a good average price on their investments. If you are paying into a pension scheme, you will already be using this method.
It circumvents the need to ‘time the market’ which is notoriously hard to do, and lowers risk substantially, by ‘drip-feeding’ money into assets, rather than investing all at once. An article by Ugly Old Goat a prominent Bitcoin trader and investor, showed that by investing $500 per month even at the worst time of the price peak in 2014, that dollar cost averaging won out.
A total investment in Bitcoin of $36,500 over 73 months resulted in growth to $872,816 in December 2018 using the DCA strategy. The maximum unrealised drawdown was 53% in January 2015 and a total of 51 Bitcoins were purchased with an average price of $708. The results for this ‘passive’ investment were comparable to the very best Bitcoin traders without any of the associated risks of trading.
Dollar cost averaging also enables you to get a mathematically favourable price. For example, the table below shows regular purchases of a notional stock. The average price of the stock is £4 (£5 + £4 + £2 + £4 + £5 divided by 5). However, because a higher number of shares were bought at a lower price, it reduces the average buy price to only £3.57 per share.
|month||investment sum||price per share||no. of shares purchased|
You may be thinking to yourself that it would be great if you bought all the stock when it was £2. Unfortunately, market timing is consistently a losing battle, as human nature generally causes people to rush in and buy as markets are climbing. They then sell as the markets decline, which is pretty much the opposite of what is required. DCA takes the emotion out of rash investing and instead operates in a formulaic manner to give you enhanced investment purchases with reduced risk.
Due to the effects of the Coronavirus pandemic, 2020 has been one of the most volatile years for stock markets. The S&P500 experienced in March, the most volatile month in it’s history with 5% average swings and 25% of it’s trading days over the year had daily swings of 3% or higher. DCA will effectively assist in managing investment risk during such volatile periods.
How to start using dollar cost averaging
- Select how much capital you want to invest in a stock or fund
- Select how often you want to invest – weekly, monthly, quarterly etc.
You need to consider the cost of any commission fees when you make regular purchases as these can add up. Some pension schemes or brokers may allow free purchases, but where this is not the case you have to balance up the cost of purchase commissions against the advantages of DCA and make you own judgement as to the frequency of investments.
For example, if a stock is trading at a high price and you have selected monthly rather than quarterly purchases, a far lower amount of stock will have been bought at this higher price but you will pay more in commissions potentially, for making more regular purchases.
Advantages of dollar cost averaging
- Prevents bad market timing and lowers risk. As money is drip-fed into the market, there are no worries about investing a lump-sum before a market crash.
- Takes the emotion out of investing – funds are invested either automatically or at defined dates.
- Effective during volatile markets – best average price is achieved.
Disadvantages of dollar cost averaging
- There is an upward leaning bias for stocks over longer periods, which means that if you are implementing DCA, you may not achieve the same return as if you invested it as a lump sum.
- You will have less income from dividends, if you are investing in dividend stocks, as much of your income will remain in cash while you are operating DCA if you have a lump sum to invest.
Value averaging or ‘buy the dip’
Value averaging (VA), is a is similar to DCA but with a marked difference. Whereas DCA buys more shares at lower prices just because they are lower, VA focuses on actively buying more shares because the price is lower and reduces buys as share prices increase.
This strategy requires investors to put in much larger sums when prices are lower, so it may not suitable for those who have restricted finances or set amounts that they wish to invest each month.
Overall, compared to DCA, VA should produce significantly higher returns as a higher percentage of shares are bought at low prices which will means higher profits as they rise in price. However, this is a more ‘active’ strategy as stocks or funds will need to be monitored and purchased when at favourable lows, compared to DCA which is mainly a ‘passive’ strategy.
Lump sum investing
Lump sum investing (LSI) is when you immediately put a large sum of capital into the market rather than spreading it out into smaller periodic instalments when utilising DCA. Due to the upward trend of long-term stock markets it has been assumed that this an effective strategy, but what is the reality?
A study by Vanguard investigating the effect of a lump sum investment versus a DCA strategy revealed some compelling results. The study analysed historical markets in the U.S, U.K and Australia and calculated the results of a $1,000,000 lump sum investment for a 10 year period, either invested immediately or with DCA over a 12 month initial period.
They found that across all markets and different time periods that LSI outperformed DCA by roughly 2/3rds on average across a mix of asset allocations.
|Portfolio||U.S (1926-2011)||U.S (1926-2011)||U.K (1976-2011)||U.K (1976-2011)||Australia (1984-2011)||Australia (1984-2011)|
|Lump Sum||DCA||Lump Sum||DCA||Lump Sum||DCA|
|60% equity/40% bonds||67%||33%||67%||33%||66%||34%|
As the length of DCA contributions increased, the likelihood of higher outperformance for LSI also increased. If DCA was increased to 36 months in the U.S for example, LSI beat DCA 90% of the time. This can be attributed to the higher average returns for stocks rather than cash. As more cash is left on the sidelines during a DCA strategy, the returns on that cash can be minimal or even negative due to the effect of inflation.
The big eye opener
The surprising element of their research was not that LSI outperformed DCA by 66% on average but that overall at the end of the 10 year period it only made between 1.3-2.3% difference to the final value of the portfolio across the 3 different markets. On a million dollar account this will make a notable difference but on smaller accounts the effect will be much less pronounced.
The advantage of DCA of protecting you against market volatility was observed during their research and it was found that DCA offered better downside protection than LSI. The average drawdown on the portfolio was £56,947 on DCA during low periods, compared to $84,001 on LSI.
Their overall conclusion is that if you have a lump sum to invest then on balance of probability you are more likely to have a slightly larger final portfolio over a long period of time than if you implement DCA on any timeframe. However, they emphasise that this is not guaranteed and that DCA can outperform or indeed either method can underperform and you can lose more than you invest in markets.
- Lump sum investing (LSI) has a higher probability of giving you marginally higher returns over the long-term if you have a lump sum to begin with.
- Dollar cost averaging (DCA) will give you more risk protection in volatile or declining markets but at the potential expense of slightly higher gains.
- If you do not have a lump sum to invest then DCA is a worthwhile ‘passive’ strategy to implement for your regular monthly savings. You may be doing this already if you have a company pension, or you can set up a SIPP (tax free + tax relief). Outside of a pension you could set up a stocks and shares ISA (tax free) or a brokerage account (taxable).
- Implement another strategy such as Value averaging (VA).