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The costly myth of dollar-cost averaging
Popular wisdom says scheduling your investments is the best way to make money. But it's actually a sales gimmick to wheedle over time what you won't commit up front.
By Timothy Middleton
Surely there's got to be a better way to invest in today's weird, topsy-turvy market.
The conventional answer is dollar-cost averaging (DCA). This idea of investing on a regular schedule over a lengthy period, in order to capture lower as well as higher prices during periods of volatility, seems plain common sense. Stock and bond markets are inherently volatile.
A Google search on the phrase yields 374,000 hits, many of them in the same vein as this quote from the Web site of giant insurance company AXA Equitable: "Dollar-cost averaging helps you avoid investing too much when the market is high, and too little when the market is low."
Here's the problem: It's bunk.
Finance professors have known this for more than 20 years, since an article disparaging the concept appeared in the Journal of Financial & Quantitative Analysis in 1979. Since then, numerous studies have confirmed this analysis. And yet, "despite more than two decades of damning evidence, DCA remains as popular as ever amongst the rank and file of individual investors," wrote Moshe Arye Milevsky of the York University (Ontario, Canada) school of business in a journal article in 2001.
Here's the solution: Invest on any schedule you wish. They all work out in the end.
The basics
Dollar-cost averaging is similar to, but not the same thing as, investing regularly scheduled amounts, such as contributions from every paycheck to a 401(k) plan. It's the alternative to investing a lump sum, such as an inheritance or an IRA rollover, typically over four calendar quarters.
Dollar-cost averaging is easy to sell to nervous investors because calamities do happen in financial markets, and they can seldom be foreseen. Think the great bear market that began in 2000, or Black Monday in October 1987, when the Dow Jones Industrial Average ($INDU) plunged 23% in a single day.
So dollar-cost averaging is always illustrated with a made-up example in which you capture lower prices along the way but finish nicely ahead. The examples are always made up because, in reality, security prices rise more frequently than they fall, by a margin of about two to one.
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Calamities are astonishingly rare. When the market is studied over long periods, dollar-cost averaging almost always produces lower returns than investing lump sums in diversified portfolios, and almost never reduces risk meaningfully.
Indeed, some finance professors have compared the approach with investing purely randomly, and give that dartboard approach a slight edge in both higher returns and lower risk.
In the real world
Here's a real-world example: last year. The period is fresh in our minds. We can remember what a roller coaster the market rode, with the Standard & Poor's 500 Index ($INX) oscillating in a band of plus or minus 4% for more than 10 months, until breaking out higher in November.
Here are three scenarios for investing $3,000 in Vanguard Total Stock Market Index Fund (VTSMX) during that period. The lump sum is invested on Jan. 2; for dollar-cost averaging, the money is invested in fourths on the first day of every quarter; in the last column, the money is invested in tenths randomly on the dates shown.
I draw the example of the last approach from the trading records of my children's IRAs. Virtually all of my investing is done the random way.
| Three ways to invest | | Investment amount and fund net asset value by date | | | | | Lump sum | Dollar-cost averaging | Random | | 1/2/2004 | $3,000 at $25.94 | $750 at $25.94 | | | 2/11/2004 | | | $300 at $27.22 | | 3/2/2004 | | | $300 at $27.12 | | 3/29/2004 | | | $300 at $26.44 | | 4/1/2004 | | $750 at 26.75 | | | 5/3/2004 | | | $300 at $26.25 | | 5/27/2004 | | | $300 at $26.36 | | 7/1/2004 | | $750 at 26.56 | | | 7/6/2004 | | | $300 at $26.25 | | 7/19/2004 | | | $300 at $25.85 | | 9/9/2004 | | | $300 at $26.29 | | 9/29/2004 | | | $300 at $26.23 | | 10/1/2004 | | $750 at 26.65 | | | 10/27/2004 | | | $300 at $26.61 | | Closing NAV | $28.55 | $28.55 | $28.55 | | Total investment | $3,000 | $3,000 | $3,000 | | Value on 12/27 | $3,351 | $3,294 | $3,315 | | Total return | 11.7% | 9.8% | 10.5% |
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Notes: Vanguard Total Stock Market Index fund. As of 12/27/2004. Assumes total investment of $3,000. Total returns include reinvested dividends as follows: 8 cents on 3/26; 9 cents on 6/25; 9 cents on 9/24 and 18.5 cents on 12/23.
Sources: Lipper, MSN Money, Microsoft Money
As you can see, I made contributions to the IRAs when I happened to think of it. I certainly wasn't trying to time the market, because only one time, on July 19, did I capture a lower price than I would have paid on Jan. 2.
In that regard, at least I did better than dollar-cost averaging, which never captured a lower price. Indeed, by pure happenstance I invested at a lower price than dollar-cost averaging ever captured (except initially) seven of the 10 times I invested.
The results
At year end, the performance of all three systems confirmed what the professors preach: The lump-sum approach fared best, returning a total of 11.7% on the investment, and dollar-cost averaging returned the least, 9.8%. The random approach landed squarely in the middle with a return of 10.5%.
While my example is hardly definitive, the academic research is. Among the articles you can find on the Web is the original one, "A Note on the Suboptimality of Dollar-Cost Averaging" by George Constantinides, and "Nobody Gains from Dollar-Cost Averaging" in Financial Services Review (1992-93). (Note: ScienceDirect requires payment to view the full article.)
What dollar-cost averaging has become is a salesman's tool to prize away in small increments the larger sum he couldn't talk you out of in the first place. But if that's what it takes to get you to invest, so be it.
However you do it, investing is better than not investing.
But what if you had happened to invest on Oct. 16, 1987, the Friday before Black Monday? In an S&P 500 index fund, you would still have been up more than 450% before the bear market began in 2000, and you'd still be up about 350% today. Compare that with your money market fund.
At the time of publication, Timothy Middleton owned or controlled shares in the following securities mentioned in this article: Vanguard Total Stock Market Index Fund.
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