Dollar Cost Averaging Today: Edited
Rob Bennett has identified the need to integrate 10-year findings and 30-year findings. When it comes to investing strategies, no one is going make it to year 30 if he becomes overly discouraged at year 10.
Dollar cost averaging is a time-tested, successful strategy. In most cases, but not all cases, dollar cost averaging reduces the average cost of the shares that you purchase. Exceptions occur in the presence of a strong trend.
What about today?
Conditions Examined
I started with an investment of $1000 and added $1000 (plus inflation) every year thereafter using my Deluxe Calculator Version V1.1A08a. I invested into an all-stock (S&P500) portfolio. I used historical sequences of S&P500 stock returns (with dividends reinvested) starting from 1923-1980. I set expenses at 0.20% of the portfolio's current balance. I selected the CPI as my measure of inflation.
I determined the real balances at years 5, 10, 15, 20, 25 and 30.
I plotted the balances versus the percentage earnings yield 100E10/P of the S&P500 at the beginning of each historical sequence. I used Excel to determine regression equations (i.e., straight-line, linear curve fits). I estimated confidence limits visually.
Equations (1923-1980 sequences)
..
Baseline for comparisons
I used TIPS with a 2% interest rate as a baseline.
Observations and Comparisons
Breaking Even
It is possible to lose money when dollar cost averaging. The total amount invested at year 5 is $6000 (in real dollars) since the balance is $1000 at the very start. At year 10, the total amount invested is $11000. At year 15, it is $16000. At year 20, it is $21000.
At years 5, 10 and 15, the five lowest balances are ALL less than the amount invested. At year 20, the four lowest balances are less than the amount invested.
At year 25, the total amount invested is $26000. All of the balances at year 25 exceeded this. Similarly, at year 30.
Compared with 2% TIPS
These are the balances when investing in 2% TIPS:
N = 5 years, y = $6308.
N = 10 years, y = $12169.
N = 15 years, y = $18639.
N = 20 years, y = $25783.
N = 25 years, y = $33671.
N = 30 years, y = $42379.
These are the balances from stocks, using today's 3.5% earnings yield in dollar cost averaging the equations:
N = 5 years: when x = 3.5%, y = $5772 (from $2.8K to $9.8K).
N = 10 years: when x = 3.5%, y = $12786 (from $4.8K to $22.8K).
N = 15 years: when x = 3.5%, y = $19936 (from $8K to $40K).
N = 20 years: when x = 3.5%, y = $33250 (from $13K to $73K).
N = 25 years, when x = 3.5%, y = $68130 (from $28K to $138K).
N = 30 years: when x = 3.5%, y = $125460 (from $55K to $225K).
Today's Odds
For an investor who is buying stocks today, the odds are that he will be behind 2% TIPS at year 5 and only slightly ahead at year 10.
Looking at the lower confidence limits: it takes about 25 years before an investor who starts out buying stocks today can be assured of being better off than someone else who simply buys 2% TIPS.
To a decent but coarse approximation, the odds are 20% that an actual outcome will be more than one-half of the way between the calculated value and its confidence limit. At year 10, the odds are about 20% that the stock market investor's balance will be below $8.8K (with $11K contributed). At year 15, the odds are about 20% that the stock market investor's balance will be below $14K (with $16K contributed). At year 20, the odds are about 20% that the stock market investor's balance will be below $23K (with $21K contributed).
Starting at today's valuations, it takes about 20 years before a stock market investor can be reasonably confident (80%+) of achieving a gain (after inflation) even though he uses dollar cost averaging.
Transition Region
The upside potential may be attractive enough by year 15 to attract a stock market investor. He has about a 20% chance of reaching a balance of $30K (plus inflation) at year 15. He has (slightly) better than 50%-50% odds of beating 2% TIPS.
Alternative Approaches
We have mentioned alternatives before. Buy TIPS now. Switch over to stocks when they become attractive. Our numbers favor 100% TIPS today.
History has validated Benjamin Graham's alternative: keep stock and bond allocations between 25% and 75%. Vary allocations in accordance with relative attractiveness (i.e., valuations). This translates into 75% TIPS today and 25% stocks.
Benjamin Graham's advice is credited with minimizing regret.
Have fun.
John Walter Russell
February 4, 2006