Is dollar-cost averaging an effective investment strategy?
A considerable number of investors employ the strategy of dollar-cost averaging as a method for allocating capital into the stock market. However, does it consistently provide the greatest value for the investment? Dollar-cost averaging involves an investor purchasing a consistent dollar amount of a particular asset at predetermined intervals, such as the first of each month. This strategy enables the acquisition of more shares during market downturns and fewer shares during periods of market highs. Over time, the approach is expected to reduce your average cost per share, provided that acquisitions align with market cycles.
Nonetheless, following an evaluation of the strategy’s efficacy, my research assistants Eray Tulun and Lilia Benrabia and I observe that, although dollar-cost averaging performs favorably on an annualized basis compared to a fixed-share strategy—where an investor acquires a constant number of shares or a percentage of stock at regular intervals—this is not universally applicable. In particular, dollar-cost averaging yields a superior performance of 0.4 percentage points annually over the long term when compared to a fixed-share strategy. However, it tends to lag behind during market downturns relative to the fixed-share approach.
In order to analyze the issue, we established a trading simulation designed to replicate the S&P 500’s performance over the last fifty years. We executed one million simulations for each strategy, utilizing historical market data as the foundational parameters for our analysis. In implementing a dollar-cost averaging strategy, we established a portfolio in which the investor commits $100 annually to the acquisition of shares in the S&P 500. Thus, if the S&P 500 were valued at $100, an investor would acquire one share of the stock index, whereas at a price of $50, two shares could be purchased. It is important to highlight that adjusting the time frame to a month in the aforementioned scenario produced identical qualitative outcomes.
In our fixed-share strategy, we establish a portfolio in which the investor acquires a predetermined number of shares, or a fixed percentage of their overall portfolio, of the S&P 500 on an annual basis. However, given the variability in price, there will be years when the number of shares you can purchase diminishes if the S&P 500 appreciates, leaving you with excess cash in years when the index depreciates. We posited that the unutilized cash would be maintained in an interest-earning account yielding a 5% return.
In all simulations conducted, the strategy of dollar-cost averaging yields a superior performance compared to the fixed-share approach, achieving an annualized advantage of approximately 0.40 percentage points. When considering a comprehensive analysis spanning two decades, our findings indicate that dollar-cost averaging yields an annualized return of 6.93%, in contrast to the fixed-share strategy, which achieves a return of 6.53% per annum. However, our analysis indicates that although the dollar-cost averaging approach performs favorably in rising markets, it underperforms relative to the fixed-share strategy during declining markets.
In a market characterized by upward movement over a span exceeding two years, our analysis indicates that the dollar-cost averaging approach generated an annual return of 23.57%, in contrast to the fixed-share strategy, which produced an annual return of 16.04%. The annual differential stands at 7.53 percentage points. In a scenario characterized by a declining market over a span exceeding two years, our analysis revealed that the dollar-cost averaging approach produced an annual return of 4.39%, whereas the fixed-share method achieved an annual return of 6.03%. This represents a disparity of negative 1.64 percentage points annually when comparing dollar-cost averaging to fixed-share purchasing strategies.
Ultimately, we examined the effects of market volatility on dollar-cost averaging in comparison to fixed-share purchasing strategies. In order to execute this plan, we evaluated our strategies across a 20-year timeframe, taking into account volatility rates of 10% and 35%. The findings indicate a preference for the dollar-cost averaging approach, which demonstrates a modest outperformance in a context of 10% volatility and significantly superior performance in high-volatility conditions. In conclusion, while a dollar-cost averaging approach is generally advisable over the long term, implementing a fixed-share strategy may prove beneficial in the context of a prolonged market decline.
