Dollar cost averaging as an alternative investment strategy
Written by Carl Turner on December 11, 2014.
In my last post I discussed why timing the markets is not a strategy that I would recommend for my clients. In this post, I would like to look at different investment strategies and draw some further conclusions to help you decide on a strategy that works.
source: Charles Schwab
Five hypothetical investors with different investment strategies were each given $2,000 per year for a 20 year period between 1993 and 2012. The research compared the value of their investments at the end of the 20 years based on the performance of the S&P 500® Index and produced some interesting findings.
It is worth noting that the study crunched these numbers over 68 separate twenty year time periods from 1926 and found remarkably consistent results.
Perfect market timer – invests consistently at the optimum time to maximise returns. Although this is included as a comparison, in reality any investor, even an experienced professional trader, is as likely to win the lottery as they are to consistently make trades with perfect timing.
The immediate investor – invests a lump sum as soon as they have money to invest. This strategy is relevant if you have funds currently in deposit account, inherit a significant amount or receive an annual bonus.
Dollar cost averaging – invests regular amounts on a monthly basis for example through a regular savings programme.
Badly timed investor – invests consistently at the top of the market.
Cash investor – does not invest in stocks at all either out of lack of interest or waiting for the right moment which remains always just round the corner.
Each of the 5 strategies invested a total of $40,000 over the twenty year period. Here’s what they each ended up with:
Unsurprisingly the perfect market timer came out top but, as mentioned above, no investor would ever manage to do this consistently over 20 years.
No surprises either that the cash investor came off worst with growth of just $11,291, less than a quarter of the return of the perfect timer.
What is rather remarkable is the return of the immediate investor, who paid no thought at all to timing but clocked up a return a mere $5,354 less than that of the perfect market timer.
The dollar-cost average approach proves consistent and delivers dependable returns in third place.
The bad timer comes in fourth but still significantly ahead of the cash investor.
Summary and how various investment strategies affect your returns
If you have a lump sum or annual bonus to invest and you don’t know whether to invest it all at once or wait, the results indicate that your best bet would be to invest at the earliest possible moment without taking current stock market performance into consideration.
If you can’t face investing all your money at once, or you don’t have a lump sum but can afford smaller monthly payments, committing to regular monthly investments via dollar cost averaging is a great option for you.
What you definitely shouldn’t do is to wait for the best time to invest. The comparison of the return between the perfect timer and the immediate investor proves that the benefits of doing so is not that impressive, even in the unlikely event that you do succeed in timing your investment perfectly.
Avoid keeping large cash investments. Even the badly timed investor earned almost 50% more than the cash investor over a 20 year period, proving that stocks offer much better potential for growth.
If you would like to talk through how these findings affect your investment strategy please do get in touch.