A lot of investors adopt the practice of dollar-cost averaging when putting money into the stock market. However, does this method always provide the best value for their investment?
With dollar-cost averaging, an investor buys a fixed dollar amount of a position at regular time intervals—say, on the first of each month—because it allows you to buy more shares when the market is low and fewer when it is high. Over time, the strategy should lower your average cost per share, if purchases correspond to market cycles.
After evaluating the effectiveness of the strategy, my research assistants Eray Tulun and Lilia Benrabia and I discovered that although dollar-cost averaging performs better annually than a fixed-share approach—in which investors purchase a set number of shares or a specific percentage of stocks at consistent intervals—this is not universally true. More precisely: Over time, dollar-cost averaging surpasses the fixed-share method by 0.4 percentage points per year; however, during downturns, the dollar-cost strategy tends to lag behind the fixed-share strategy.
A million simulations
To investigate the matter, we created a trading simulation designed to replicate the behavior of the S&P 500 from the last fifty years and conducted one million simulations for each approach, with historical market data serving as the basis for these simulations.
In our dollar-cost averaging approach, we established a portfolio wherein annually, the investor committed $100 towards purchasing shares of the S&P 500. Thus, if the price of the S&P 500 stood at $100 per share, the investor acquired one share; however, if the price dropped to $50, they could buy two shares instead. It’s worth mentioning that adjusting the timeframe from yearly to monthly in this example produced similar overall outcomes.
In our fixed-share approach, we established a portfolio wherein annually, investors purchase a predetermined quantity of shares (or a consistent fraction of their total investment) from the S&P 500 index. However, due to fluctuating prices, certain years might see fewer share purchases than before when the S&P 500’s value has risen, leaving surplus funds. Conversely, should the S&P 500 decrease in value, additional money will remain unspent after purchasing these predefined amounts of stock. For this unused capital, we presumed it would be placed into an interest-earning account yielding a yearly return of 5%.
In every simulation conducted, dollar-cost averaging surpasses the fixed-share strategy by approximately 0.40 percentage points annually. Over varying market conditions spanning two decades, our analysis shows that dollar-cost averaging yields an annualized return of 6.93%, whereas the fixed-share approach provides an annualized return of 6.53%.
Up vs. down
However, we discovered that although the dollar-cost averaging approach performs well in rising markets, it falls short compared to the fixed-share strategy when markets decline.
For a market that goes up over a period of two-plus years, we found that the dollar-cost averaging strategy yielded a return of 23.57% a year while the fixed-share strategy returned 16.04% a year. That is a difference of 7.53 percentage points a year.
During a span of more than two years when the market was down, our findings indicated that the dollar-cost averaging approach provided an annual return of 4.39%, whereas the fixed-share method offered an annual return of 6.03%. Consequently, this resulted in a yearly discrepancy of negative 1.64 percentage points favoring the fixed-share technique over dollar-cost averaging.
Ultimately, we examined how market fluctuations affect dollar-cost averaging compared to fixed-share purchasing. For this purpose, we applied both methods across a 20-year timeframe, considering volatilities of 10% and 35%, respectively. Once again, the outcomes favored the dollar-cost averaging approach; it performed slightly better under conditions of 10% volatility and significantly surpassed the alternative method when facing higher volatility levels.
In essence, over time, using a dollar-cost averaging approach is generally advisable; however, switching to a fixed-share strategy might prove beneficial during a prolonged market decline.
Derek Horstmeyer He is a finance professor at the Costello College of Business, located within George Mason University in Fairfax, Virginia. You may contact him there. reports@wsj.com .
Post a Comment