How Great Is Dollar Cost Averaging? You Don't Know The Half of It

I’ve mentioned on a number of occasions that the S&P 500 has been nothing short of disappointing since the turn of the century. I hope that every single reader who is still adding money to their investment portfolio on a regular basis (“dollar-cost-averaging”) has thought to themselves: that’s good for me! If you didn’t, let me get you there. You see, low returns on stocks keeps prices depressed and allows savers an extended opportunity to buy more shares that should eventually shoot higher. And more shares at these higher prices means more wealth!

We all feel better about our investments when they are gaining in value. When they return more than their long-run average, we’re just borrowing returns form the future, yet we feel increasingly optimistic about what lies ahead (we’re nothing if not extraordinary followers of short-term trends). In reality, as savers we should feel better when we get a chance to buy shares on sale. No one seriously thinks a diversified stock portfolio has reached a peak or that it will decline and never come back. So downturns are just buying opportunities.

Want to see the wonders of dollar-cost-averaging in action? Consider the 15-year period from 2000-2014. The Vanguard S&P 500 fund earned a paltry +4.1% per year. That’s not nothing of course, but it is nothing more than the return generated by the Vanguard Short-term Bond Index fund—which achieved this result with 7X less volatility and not a single negative year!

You might think to yourself, what a loss, I’ve sunk $1,000 into stocks every month for 15 years and have little more than ultra-safe bond returns to show for it. But you’d be wrong. Despite only saving $180,000 cumulatively, your total ending portfolio value was $352,202—twice as much as you saved—for a rate of return on your contributions of +8.5% per year!

How can this be? The S&P 500 only averaged +4.1%. But not all of your savings averaged 4%. Some money went in after 2001 and 2002 and 2008 and 2011 when shares were extremely depressed and subsequently earned returns of +12%, +15% and +20% or more. That’s the benefit of consistently buying stocks—they have high long-term expected returns and they’re volatile, which means that on regular occasions, if you keep investing, you get to buy them at depressed prices with much higher-than-average expected returns.

We can see the opposite effect when we observe the outcome of dollar-cost-averaging the same amount into the low-risk bond fund. Remember, it had the same annual compound return over the 15-year period. But the amount of accumulated wealth was only $228,294, almost $130,000 less than what you netted from the S&P 500. The internal rate of return on the savings into bonds was about 3% per year, only about 1/3 of what the contributions would have earned going into stocks.

I personally find this astonishing. I think dollar-cost-averaging on a regular and disciplined basis is the most underrated investment strategy there is. It takes full advantage of high stock returns, turns the annoying volatility of stocks into a benefit, and gets an additional lift from compound interest over time. Just remember, it only works with stocks (don’t buy for a minute the guidance that young investors should own a chunk of bonds) and it only works if you stick with it. On that latter requirement, it’s better to learn discipline young because we become more set in our ways as we age and staying-the-course will be absolutely critical for your plan once you’re in retirement. If you’ve been blowing yourself up trying to time the market for a few decades as an early saver, going cold turkey with a buy-and-hold approach at 55 or 60 is next to impossible.

Source of data: DFA Returns 2.0

Source: How Great Is Dollar Cost Averaging? You Don’t Know The Half of It

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