Introduction

There is a lot of people on the internet that say that instead of putting all of your money at once in the market, you should instead divide that lump sum over a certain period of time with equal installments. The underlying logic is that if the market falls after you've invested a lump-sum, it will be devastating. Instead the dollar cost strategy avoids such tragic event by not investing everything at once and instead spread your bets at different moments through time. Does it really make sense ? We have done some Monte Carlo simulations that are not in agreement with the common sense picture that is “sold” on the internet.

Dollar Cost Averaging: Definition

In order to define properly the terms we are going to consider a very specific case: you want to invest 100'000 USD into an SP500 index and you have two possible choices:

1. put the total 100'000 USD in an SP500 index in one time;
2. put 5'000 USD per year for the next 20 years.

What is the best strategy in terms of expected profits ? This question does not seem easy to answer intuitively, because if the index goes down just after you've made your investment, you can save a lot of money by choosing the option 2 (dollar cost averaging). However, if the market goes up significantly just after the investment, then the strategy 1 would allow to pocket a quite big gain (strategy 2).

The Simulations & Results

To answer that question, we have decided to create a Monte Carlo simulation, where we consider that the SP500 returns are approximately normal with a mean of 7% and a standard deviation of 14%. This assumption is not verified in reality, as we know that the market returns have “fat tails”. However, as a first simple assumption, let's consider it as a true to build an intuition about what is happening with the dollar cost averaging strategy.

Figure 1. Portfolio value for the buy and hold strategy and for the dollar cost averaging strategy

In Figure 1 is represented the average portfolio value for the buy & hold strategy and for the dollar cost averaging (DCA) one. The result is rather clear: you better choose the buy & hold strategy unless you want to leave 200'000 USD on the table at the end of the 20 years.

There is as well something else that was not considered in my previous simulation: the transaction costs. If you invest a large sum, your broker will charge less than if you do several trades with lower sums. So actually, a realistic simulation would be even more in favor of the buy & hold strategy. But why is it so? It does not look like a very intuitive result… The reason why it is better to follow a buy & hold strategy is because of little detail that you should play in your favor.

Dollar Cost Averaging: The Bias

The dollar cost averaging protects you against a big drop that might happen just after you put all of your money in the market. However, you are just trading that risk against another risk: the market might as well go significantly higher.

It turns that the market is rigged … in your favor !! Or as Warren Buffet said once

“The stock market is a device for transferring money from the impatient to the patient”

What he meant is that if you buy an asset or etf of the overall market, and keep up with it through the ups and downs, the probability that you end up winning some money at the end of the day is pretty high. In fact, on average if you buy an etf such as SPY, the probability of profit after one year of holding it is close to 70%.

Therefore, the trade of exchanging the risk of a drop against the risk of a rise in the market is not good for the investor in the long run, because it basically translates into a bet against the market. Since the market has higher probability to go up than down over long periods, the dollar cost averaging strategy will not reach the full potential of a simple buy & hold strategy.

This picture can actually be verified if we consider that the market has an expected return of 0%. In that particular case, it would not matter to buy & hold or to dollar cost average your investments. But let's be frank: if the market returns 0%, we are far better to have our money on a savings account.

Figure 2. If the market returns 0%, both strategies are equivalent at the end of the 20 year period

Conclusion

The conclusion is pretty simple: buy & hold is a much better strategy than dollar cost averaging in terms of profits (what we care about in the end). As long as you hold, there is a high probability you'll be profitable in the long term.

Moreover, in terms of transaction costs it is better to execute one big trade instead of doing lots of small ones. This tends to favor the buy & hold strategy even more.

Finally, don't believe everything that is on instagram or facebook, such as the following example…

If you would like to cite the present content, please use:


@article{fabio2021dollarcostaveraging,
title   = "Dollar Cost Averaging: Does It Work ?",
author  = "Capela, Fabio",
journal = "capfab.io/blog",
year    = "2020",
url     = "https://capfab.io/blog/dollar-cost-averaging-does-it-work"
}