Fad or Fact? Understanding Dollar Cost Averaging Strategy.

Most of us would be familiar with the concept of dollar cost averaging (DCA). We have all heard the saying that time in the market is more important than timing the market.

DCA’s disciplined approach to investing enables investor to invest regular quantities of their capital over a set period of time, which diminishes investors’ fears of entering the market at the wrong time and eliminates rash investment decisions.

The strategy’s cost-averaging effect provides investors the benefit of accumulating more units when prices drop while keeping costs low if prices pick up, thus helping an investor gradually build up their wealth over the long term.

However, from an investment performance perspective, how has the DCA strategy fared?

Using Robert Shiller’s US S&P index data spanning over more than 150 years (from 1871 to 2022), we shall look at how the DCA strategy has performed for the investment periods of 5, 10, 20, 30 years. Table 1 below shows the investment returns on a total return basis (with dividends re-invested).

What do the results show?

Over a period of 151 years, we can see:

- The average return is more than 9% for all investment periods. (5,10,20,30 years)

- The lowest return ranges from -17.31% (5 years) to the highest return of 33.66% (5 years)

- The probability of positive returns is also more than 80% for all time periods to 100% positive returns for both investment periods of 20 and 30 years.

Let’s also look at the dollar value returns of an investor who used a monthly DCA strategy (for 5, 10 and 30 year periods) to invest in the US S&P index in recent times.

- An investor who invests $100 per month beginning 31 Jan 2017 would have seen $6,000 grow into $9453 at the end of 5 years on 31 Jan 2021, translating into an annualised return of 9.5%.

- A monthly DCA plan of 10 years ($100 per month, from 31 Jan 2012 to 31 Dec 2021) would have seen $12,000 grow into $27,133 at the end of 10 years, translating into an annualised return of 8.5%.

- A monthly DCA plan of 30 years (100 per month, from 31 Jan 1992 to 31 Dec 2021) would have seen $36,000 grow into $221,875, translating into an annualised return of 6.2%.

From the investment results presented by Table 1 and 2, it is evident that a DCA strategy works and is a successful approach to building up a long term investment portfolio.

What happens to a “Lump sum” investment strategy then?

Table 3 presents the dollar value results of a “Lump Sum” investment strategy based on the same time periods of 5, 10 and 30 years as well as their respective annualised returns.

From the results shown by the table above, the lump sum investment strategy clearly delivered stronger returns with annualised returns ranging from 10.5% to 16.8% (outperforming the monthly DCA strategy with annualised returns ranging from 6.2% to 9.5%).

This suggests that while DCA has its benefits, investors who have larger sum of capital for investment should put their money to work sooner rather than later, as the comparison between the two strategies demonstrate the high opportunity cost of keeping funds un-invested.

In conclusion, historical evidence leading till today shows that the dollar cost averaging strategy is a successful approach to long term investing and is highly suited for investors who do not have large starting capital. DCA also provides investors the benefit of maintaining a disciplined saving approach, diminishing the emotional aspect to investing while providing continuous participation in the market. However, investors with a larger sum of capital should opt for the lump sum investing approach which can make a significant difference to investment returns.

Original Source: iFast Financial Pte Ltd