Simple proof that dollar cost averaging works

Personal finance, Value investing

One of the proven and advocated tenets in value investing is , and it goes hand-in-hand along with the idea that matching market performance is easy (just buy the index), but beating it is hard. But does it work?

Here’s a simple calculation to show that it does. I downloaded monthly historical prices for SPY and compared returns if I had arbitrarily decided to invest $100,000 on April 2, 2001 and hold SPY for five years, or invest $5000 over the next twenty quarters (for a total of $100K) instead. Below are the returns:

Method Value on Jan 3, 2006 % return
$100,000 invested all at once on
April 2, 2001		 $107,817.70 8.49%
$5,000 invested at the beginning of every quarter for 20 quarters $123,108.60 23.11%

The results work in a down market too. You’ll lose less by dollar cost averaging than without it:

Method Value on July 3, 2003 % loss
$100,000 invested all at once on
April 2, 2001		 $80,854.34 19.14%
$10,000 invested at the beginning of every quarter for 10 quarters $99,462.33 0.54%

Why does this work? Essentially, you’re evening out the ups and downs and uncertainties. By purchasing stock at one point, you’re gambling that that’s the best price you’ll get and it’ll only go up from there, whereas by dollar cost averaging, the odd number of shares you’re getting or not buying add up over time. About the only time this won’t work is when a stock only goes up and never goes down. Do you know of anything that fits in this category?

***************************************************

Look Good at Work and Become Indispensable Become an Excel Pro and Impress Your Boss


***************************************************

Posted on 12 April 2006 by Leslie Currently, Comments and Pings are both off.

One Feedback on "Simple proof that dollar cost averaging works"

How should I invest for 3-7 years out? | Experiments in Finance

[…] On the stock portion, to be entirely safe, you should probably consider dollar-cost averaging into the ETF or mutual fund you’ve chosen. This is a proven-to-be-successful tenet for buying stocks, which is a real rarity. Keep in mind that if you do this, you might be better off investing in a mutual fund rather than an ETF because most brokerages will require commissions for trading ETFs, whereas you may be able to regularly invest in no-load mutual funds without paying extra comissions, because most mutual funds are already set up for this type of regular investment. Still, you might want to calculate the fees on the index fund and weigh them against the trade commissions for buying an ETF. In my case, I found that the $10 per trade on an ETF easily outweigh the limited selection of no-load index funds that I have access to, and I’ve got the discipline to put regularly put in and calculate the # of shares to do this myself rather than use an automated system. […]

03 July 2006 at 12:25