Important Follow-Up on Dollar-Cost Averaging

Important Follow-Up on Dollar-Cost Averaging
by Nilus Mattive Dear Subscriber,
Three weeks ago, I showed you why dollar-cost averaging would have worked very well since the first time I mentioned the strategy here in Money and Markets during the summer of 2008.
I got a lot of positive feedback on the story ... including much amazement that this simple approach could have produced such a powerful result during such a tumultuous time for the stock market.
Of course, a few people also chimed in with questions and concerns. Some wondered whether I just chose favorable dates for my case study. More importantly, a couple of the comments suggest to me that my major point about dollar-cost averaging got lost in the shuffle.
So today, I want to look at a "worst-case scenario" with dollar-cost averaging ... and clarify a couple other points I was trying to make about the strategy ...
A Worst-Case Scenario: A Tech Bubble Investor
Begins Dollar-Cost Averaging in 1999!
I have already shown you how a Great Depression investor would have fared with dollar-cost averaging. And more recently I explained that the strategy would have worked well during the market's latest swoon.

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But what about an absolute worst-case scenario? Well, I can't think of anything worse than beginning to buy stocks around the new millennium ... when prices were exorbitant and investor expectations were sky high.
In fact, as one commentator on my blog put it ...

"I feel bad for the 30-somethings that started to pour money into index funds in the mid to late 90s."

I know a lot of people who fall into that category ... and a quick look at a chart of the S&P 500 will explain why the last decade has been tough for them:

As you can see — almost ten years later — the S&P 500 index is still 30.5 percent below where it was when the new millennium started!
So does that blog poster have a point? Yes.
Clearly, a decade of negative returns is one of the worst-case examples we can find for the U.S stock market.
The full data table is too long to display in this column, but you can see it by clicking here.
As before, I assumed our hypothetical investor put $1,000 every month into the S&P 500 starting back on December 31, 1999.
If you look at the data table, you'll also notice that I highlighted all the times when our imaginary investor purchased stocks at a higher-than-current price. The vast majority fall into that category!
Now, here's how it would have panned out overall:

Total investment: $117,000.
Total value of the investment ten years later (based on the S&P 500's recent price of 1020): $103,155.
Return over the ten years: -11.83 percent or about -1.2 percent annually.

Obviously, that isn't a great result. In fact, you'd be right to assert that even a regular old money market fund would have performed substantially better over the same period.
But here's the thing ...
That Criticism Assumes That You Were NOT Diversified
AND That You Had Perfect Foresight!
Look, it's easy to sit here today and say that a money market or a bond index fund would have been the better place for all of your money over the last ten years.
But that isn't how reality works. We never know — with absolute certainty — where a particular market is going next. So we rely on the best indicators and historical data we can find.
Historically speaking, there have only been a few periods in the last century where U.S. stocks have underperformed other asset classes like cash and bonds.

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And even if you began investing at the very point when such an anomaly began, you only lost about 1.2 percent a year with dollar-cost averaging!
Meanwhile, nowhere does the law say that you weren't allowed to put some of your monthly dollar investments into other assets like bonds or even precious metals.
In my opinion, that's precisely what you should have been doing. And should continue doing today.
Which brings me to my main point about dollar cost averaging — it is a great investment strategy for people looking to build a solid portfolio over time ... with minimal timing risk.
I'm certainly NOT using it to prove that investing in any particular asset class is the right way. Only that it helps minimize the risk that you're getting into a particular investment at the wrong time.
Think about it. Someone looking to put a lump sum into bonds faces the very same challenge as someone putting everything into stocks — namely, that they're going to get in at an inopportune time.
By allocating a set dollar amount to a broad bond index fund at set intervals, they would effectively limit their risk quite well. It's a good alternative to the laddering technique I've discussed in the past.
Last, A Few Words About Case Studies and Dates ...
Whenever we want to look at how a given strategy has performed historically ... we have to choose a beginning date and an end date.
Sure, it's possible to backtest something over every possible period. But to keep things simple, I generally pick out a couple timeframes that cover most major possibilities.
If you look at the example we just did today, you'll notice how even going back a couple years earlier would have turned the study from a worst-case into a "pretty decent case scenario."
Ditto on the end date. Based on current prices, we show a loss but ...
If the S&P 500 goes to 1,300 next year, our hypothetical dollar-cost averager will go from a 1.2 percent annualized loss to a 1.2 percent GAIN ...
And if the broad market simply gets back to its price when the averaging began (1469.25) ... our hypothetical investor will be up 27 percent over the period, or 2.7 percent annually.
Again, not a barn-burning return ... but still not bad during one of the most volatile decades for U.S. stocks ever.
So by all means, let's continue to aim for better timing and better results than the averages. As you know, I am all for using more advanced approaches to get outsized returns and lower risk.
But let's also recognize the power of simple approaches like dollar-cost averaging ... for ALL asset classes ... and particularly for accounts with long-term investment goals such as retirement.
Best wishes,
Nilus
P.S. I also feel compelled to point out that none of my examples are factoring in dividend payments at all. The effect of steady cash payments would have made a big difference in a stock investor's performance during our "lost decade" in stocks.