Bulkowski's Dollar Cost Averaging

Written and copyright © 2010-2011 by Thomas N. Bulkowski. All rights reserved.

This article discusses dollar cost averaging. Despite being a popular method to ease funds into the market, research shows lump sum investing does better than dollar cost investing. Author and trader Thomas Bulkowski puts dollar cost averaging to the test.

Dollar Cost Averaging: What Is It?

Dollar cost averaging is a method of spreading out a lump-sum investment over time to take advantage of market fluctuation. For example, if you plan to buy a stock on the first of every month and the price drops before you buy, you will buy more shares. If the price rises before the purchase, you buy fewer shares. The belief is that over time, you will be able to buy in at a good price, spreading the risk and reducing the chance of buying near the top of a market.

Dollar Cost Averaging: Is It Useful?

Many people use dollar cost averaging when contributing to their individual retirement accounts or 401-K plans. They do this through payroll deductions automatically, where a portion of their paycheck is invested in the company's stock or a chosen mutual fund. It's not a bad way to build a nest egg.

Dollar cost averaging dos not really concern itself with periodic investment, but rather how to invest a lump sum. If you win the lottery or inherit money, then you may face the problem of how to invest those funds. That's where dollar cost averaging shines. Unfortunately, the following test reveals that dollar cost averaging sucks, to put it bluntly.

Dollar Cost Averaging Test Methodology

I used the Standard & Poor's 500 index from January 1950 to May 2010. On the first trading day of the month, the test bought $12,000 worth of the index and held it for a year before selling it at the closing price for the period. Then I advanced to the next month, investing $12,000 and held that trade for another year. I repeated the test of overlapping trades of 1 year duration until the end of data.

Then I started the test again, buying $1,000 at the start of each month instead of $12,000. At the end of a year, the full $12,000 was invested in the S&P index just as it was in the prior test. I sold all shares of the index at the closing price on the last trading day of the period.

The only difference between the two is the first test invests the entire $12,000 at the start of the period. In the second test, $1,000 is spent each month until the money is gone. Both holding periods span a year. In the dollar cost averaging case, the hold time for the first $1,000 is a year, the next $1,000 is 11 months and so on. That may sound like it prejudices the test, but that's the trade-off you make if you dollar cost average your investment.

I did not take commissions, fees, slippage, taxes, interest on uninvested money, or other factors into consideration.

I totaled up the profits of each trade and the next section shows the results.

Dollar Cost Averaging Test Results

How did the two do? The following table shows the results.

The lump sum investment made $705,147 over the 60 year test compared to dollar cost averaging's gain of $371,445. When comparing the profit or loss for each annual competition, the lump sum technique wins 500 times and the dollar cost averaging method wins 212 times -- 70% to 30%.

If you inherit a lump sum or win the lottery, invest the whole thing at once and then start praying.

-- Thomas Bulkowski

Written and copyright © 2010-2011 by Thomas N. Bulkowski. All rights reserved. Polymer physicists are into chains.