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Here’s a Winning Market Strategy for You
July 6th, 2011
This strategy is ultra boring, but it delivers solid results
There are two catches: it won’t beat a buy-and-hold in the event the stock market were to go more or less straight up, and the strategy is about as exciting as watching grass grow.
Dollar-cost averaging
The strategy is dollar-cost averaging: Periodically investing a set sum in the market. Because this set amount ends up purchasing more at lower prices and less at higher prices, the strategy is a close variant of “buying low and selling high” which, by definition, is guaranteed to make money.
Performance to date
How has dollar-cost averaging performed in the U.S. stock market? Consider a portfolio that invested $1,000 at the end of each month in the Wilshire 5000’s total-return index, starting at the top of the bull market in the fall of 2007. As of the end of this past June, this portfolio would be worth $56,143, representing a 24.8% profit on the $46,000 invested. The portfolio’s internal rate of return is different, since the $46,000 wasn’t invested all at once.
Lump Sum
In contrast, if you had invested that $46,000 in a lump sum at the beginning of this 46-month period, your portfolio today would be worth $43,594, or $12,549 less than if you had dollar-cost averaged.
No timing
Furthermore, that the dollar-cost averaging portfolio earned this additional amount without making any market timing guesses. Its profit was automatic, given the discipline of investing a set sum in the market each and every month.
401(k)
This is one of the reasons why the average 401(k) account is worth more today than at the bull market peak. Investors almost always pursue dollar-cost averaging approaches in such accounts, since they rarely have any other choice. Dollar cost averaging has worked over longer periods as well. A dollar-cost averaging portfolio would be well ahead of a buy-and-hold over the period beginning in early 2000, for example.
Not in the 1990s
The approach lagged during the decade of the 1990s, when the stock market underwent few serious corrections, much less a bear market. For the 10 years through December 1999, for example, your $1,000 per month investment would have turned $120,000 into $358,447, representing a 199% profit on original investment, equivalent to 11.6% annualized. Buying and holding, in contrast, produced an 18.5% annualized return over that decade.
Deciding
In deciding whether to pursue a dollar-cost averaging strategy yourself, therefore, you need to gauge your willingness, should the future be a replay of the 1990s, to make “just” 11.6% annualized when the market itself is rising at an 18.5% annualized rate. What you get in turn for that willingness: The assurance that, if and when the market endures a serious downturn, you will perform far better than a buy-and-hold.
The psychology
While many might have such willingness, the bigger problem with dollar-cost averaging may very well be a psychological one. This strategy is boring. The question to ask yourself: Are you willing to forego the excitement of correctly calling the market’s zigs and zags in order to be more or less assured of a decent, market-beating return over an entire market cycle.
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June 14th, 2011
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