January 25th, 2010
08:49 AM GMT
“Dollar cost averaging” is a fancy term for a simple concept. It’s the idea of investing a set amount of money at regular intervals, usually in individual stocks or a mutual fund, regardless of where the markets might be heading.
Many of us follow the strategy, particularly when we’re able to invest money from a regular paycheck using pre-tax dollars. I’ve done so for years.
However, each month when the statement comes, I tend to just look at how my overall investments have fared. Check the number, then toss the statement in a drawer. (From late-2008 through mid-2009, many statements weren’t even opened)
After more than a dozen years of following the concept of DCA, I finally decided to sit down with a calculator and crunch the numbers: Does it really work?
I picked a widely held mutual fund and tracked how it traded on the first trading day of the month. (For the record, it was hardly a scientific approach. I did not factor in possible dividends. And of course this was just one of countless mutual funds on the market today.)
I put in a hypothetical annual investment of $3000.
- To dollar-cost average, I invested $250 on the first trading day of each month. I tallied up the number of shares purchased.
Here’s how it fared after three years: Dollar-cost inched out a random approach by $35.
1. Dollar-Cost Averaging – 154.93 shares totaling $9,148
How about five years? Things changed. Looking back over historical figures since 2005, the lump sum strategy took the lead, albeit by about $45 over DCA.
1. Lump Sum Investing – 250.85 shares totaling $14,812
Now I was really curious. I took it back to 2003 (at this point my desk was littered with Excel spreadsheets and my calculator was asking for a break)
After seven years, the lump sum approach still held the lead, now by $463. Dollar-cost averaging was second. The random approach finished third.
1. Lump Sum Investing – 387.98 shares totaling $22,910
The findings turned my investing brain into mush.
Then I took a step back, and looked at the two years over the past decade where fear and volatility entered into the equation – points when an investor would be most inclined to hold off on investing, or to panic and simply hit the sell button.
As Puru Saxena, puts it “Markets have been run based on greed and fear for centuries, and they will continue to be run on greed and fear for centuries to come. If you want to keep your emotions out of the game, then investing in a disciplined manner on a monthly or quarterly basis is the best option for most people.”
In 2001 and 2008, dollar-cost averaging outperformed the lump sum approach, and it wasn’t close. (In 2001, the dollar-cost approach saw declines of 17 percent while the lump sum strategy fell 20 percent. In 2008, it was 23 percent versus 36 percent.)
And that’s why many advisors point to the dollar-cost approach in the long run. It takes fear and greed out of the equation. It can help prevent investors from making the all too common mistake of buying high, and selling low.
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