Dollar Cost Averaging: How to beat a "flat market"
January 5, 2012
The S&P 500 has a negative return between February 2000 and today when dividends are excluded. That means if you put $30,000 in the stock market in 2000 it would be worth less today! Why the heck would I want to endure the risk of investing in the stock market for 11 years for no return on my money?!?!
I'm sure you've seen many similar news stories asking the same obvious question. It's been an extremely rough decade for investors who've ridden the more-painful-than-usual roller coaster ride. So why should you gamble your hard earned money in the stock market??
Well, the sad part is nothing is more proven to provide a larger return for your money over a long period of time than investing in the stock market. Gold has been on a nice run, but its worthiness has an investment is questioned due to it's volatility and long term track record (more on this in another article). Even CDs and money market accounts are hardly earning anything right now; five years ago you could find high-yield savings accounts with 5% returns; today those returns are down to .7%!
There's still hope, I promise.
When you look at the stock market over the last 12 years, it's been anything but flat. In fact, the S&P 500 went all of the way down to 735 in February 2009 and all of the way up to 1,549 in October 2007! Today it stands at 1,277. How do you take advantages of the big swings (especially on the down side)?
The answer: Dollar Cost Averaging
Dollar cost averaging (DCA) is the practice of investing regular amounts of money on a fixed timetable. Basically, it's conceding the belief in your abilities to time the market and instead letting the calendar pick your purchase dates.
I dollar cost average by making regular contributions into my 401K from my paycheck. This is the most common way people DCA because it's so easy to do through your company.
Running the numbers
As mentioned before, if you put $30,000 in the stock market on February 2000, you would have less today. However, what happens if instead you put $200 a month into the stock market starting in February 2000?
No way the $200/month could even come close to the $30,000 investment, right? Well, prepare to be amazed (Ok, maybe not amazed, but at least act surprised!).
For this analysis, I'll use the S&P 500 index fund (SPY) to track your $200/monthly investment. Index funds are meant to mimic the movement of the market so it will match the fluctuations of the S&P 500 like a mirror. Your $200 contribution will automatically enter the market the first of the month. Here we go:
Total contribution period: 143 months (just under 12 years)
Monthly contribution: $200
Total contribution amount: $28,600
Value after 12 years: $35,317
There you have it… by dollar cost averaging, you would have had an overall return of 24.5% on your money. Granted, it's still pretty low when annualized, but at least it's better than losing money.
The benefits of DCA are really transparent when you look at the monthly data. The minimum price of SPY was $68.53 in September 2002; so your DCA purchase got you 2.9 shares of SPY while today it's at $127.5 (1.56 shares).
This is somewhat reassuring to me because it proves that even during one of the worst stock market periods in history, money can still be made if you invest for the long term. If the investing purchase decisions were left up to me, I probably wouldn't have bought in Sept 2002 because I guarantee the "world was coming to an end" according to the media.
Instead, I'll let my DCA do the work for me and not worry about timing the market. If you get in a good routine of doing this now, it will pay off handsomely when we finally begin our next bull run.
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Comments
It Works
This is a very wise post. Especially right now. I have been an investor for many years and have used this to make the nest egg I have today. The challenge is to not panic when the market does what it does. If you do your home-work, have chosen wisely and have diversified your risk you will come out ahead. As always, I greatly enjoy your posts, Susan Cooper
Susan - it's reassuring to
Susan - it's reassuring to see you're still 'bought in' on the long term benefits of the market since your many years of investing have surely taken you through some tough times! When the stock market was tanking in 2009, I remember a friend who came into the office and said he sold all of his shares... it turns out he sold within three days of the exact bottom of the market. I use that as a reminder when I start to get nervous.
All depends on your goal and style...
My view of investing in the stock market is that is all comes down to your style. Some people are so-called "passive" investors... those who don't really want to deal with the short term emotion of the market, and believe that by consistently putting money into stocks every month rain or shine, everything will work itself out over time. Then, there are investors like me who like the action, and believe by making an effort to time the market, one can get much further, much quicker. Of course there are tons of variants in between, but these are two camps with different philosophies and personalities.
I realize my timing the market view will be unpopular, but I find dollar cost averaging to be a very risky strategy. Why? It comes down to results and practicality for me... Using your S&P example, we're talking 2%/year over the past 10 years... ok, lets throw in dividends and say a 3% average. The stock market can be a dangerous game... and I am playing it for ~3%/year ? That's not a good risk/reward proposition in my view. Heck, I can buy a 5 year CD to get me that guaranteed stress free. And before you show me a chart of Apple and talk about the wonderful gains over the past years, I can easily show you many companies that are worth less today than they were 10 years ago and 5 years ago. In 2000, Walmart was worth $69... it sank to $43 in 07 and has managed to climb up to $57 as of today, 18% less that in 2000. Tons of people invest in Walmart because it's one of those companies "that will always be around". DCA or not, my gains (if any) with Walmart would be very small. In 2000, Ford was worth $32, and it went on an 8 year slide... reaching its low of $1.32 in 2008. Now it's back to $11.71, 64% less than in 2000. Many people are convinced that as long as they stick with these "name" companies, they will be ok over time if they keep throwing money at them and avg. out their costs. I respectfully disagree with that approach.
In addition, on paper DCA sounds nice, but tell me how many people were actually sticking to that during the 3 year market slide of 2000-2002? 3 years is a REALLY long time... and the market lost 50% during that period. That's a whole boatload of money. In order for DCA to work, one has to diligently invest during those bad times, and the facts show that this just does not happen. Panic spreads like wildfire and people run for cover... It's human nature... we may be able to resist for a little while, but soon enough the tv commentators will have us believe that the market will never come back and we eventually sell. How many kept buying stocks long in 08 when all we heard about was the Lehman Bros collapse along with Freddie and Fannie. It was like people were talking about the end of the world then. "Get out while you can". Look at the chart and see how swift the market decline was... Instead of it taking the market 3 years to drop 50%, it dropped almost that much in 1 year.... Panic. It's human nature, so that's where the impracticality comes in for me.
So, what's my suggestion? Time the market! Yes, I know, I know... Warren Buffet said it's impossible and a waste of time, so I should probably stop at this point. But, the fact is, there are thousands of other very successful stock investors not named Warren Buffet who are exceptional at it.... I met a guy who retired at age 43 who did just that, and he is not nearly as aggressive as I am with regards to stocks. He's just extremely disciplined and unwavering in his approach.
There are so many ways to invest in stocks. I prefer to be active in the market on a regular basis making trades that I think will get me further towards my goal. But, timing the market doesn't mean a person has to be aggressive like me. Lets take the S&P example again... my view is that the S&P is in heavily oversold zone when it is 900 or below... and in heavily overbought zone when it is 1400 or above. For a very conservative investor, I would say keep your money in a CD till the S&P comes near/into that oversold zone, and then gobble up as many shares of your favorite stock as you can and chill out while it rises. Maybe you hold until S&P gets to 1200ish just so you make sure you're locking in your gains. Also, when the market gets into overbought zone, short a stock (or buy a shorting etf), and make money while the market crashes. Amazingly, many people don't realize that they can make just as much money when the market is going down as they can when the market goes up. Why should I buy stocks long 2000-2002, when the market was in a clear downtrend and I know I could actually be MAKING money during that time by shorting?
By waiting patiently for the market to reach overbought and oversold levels, you greatly minimize your risk and put your gains on overdrive. Lets take my Ford example again... after the S&P reached oversold zone at the end of 08, it was worth $1.32... today it's worth $11.71. That is a stellar gain in a couple years. The S&P gained 40% during this time. That's the type of movement that makes investing in the stock market worth the risk for me. The market is like a rubber band... when it stretches to extreme levels, 1) you know there is only so much further it can go, and 2) when it snaps back in place, it does so with force. These are the opportunities we can wait patiently for and make supersized profits on when they occurr. I prefer not to wait years for these opportunities to show themselves, I try to find them on a weekly basis, albeit on a smaller scale.
Anyways, I am done rambling on about the market... Just my 2 cents... Not expecting my opinion to be popular... just another perspective.
Percy
Percy - I sincerely
Percy - I sincerely appreciate the amount of effort and time you put into intelligently stating your point. Also, I can't do this retort justice by replying in the comments section. I'll work on my reply and defense of DCA vs market timing and republish along with your comment in a new article. Thanks again!!
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