Don’t Give up on Dollar-Cost Averaging!

July 21, 2008

At the time of this writing, Vanguard’s S&P 500 Index Fund (VFINX) is down 14.04% year-to-date (not including dividends). Where would you be had you dollar-cost averaged into VFINX during the year? To arrive at that answer I assumed a few things:

1. Invested $500 on the 1st and 15th of each month.

2. If the 1st and the 15th fell on a weekend or holiday, I used the price for the trading day preceding the 1st or the 15th.

3. I assumed this was a 401(k) account.

So, here’s where you would stand right now had you invested $500 into VFINX on the 1st and 15th of every month during 2008:

So, you would have invested $7000 during the year and it’s worth $6,509. You’re down 7.01%, right? Not exactly.

Why?

Because you weren’t fully invested the entire year. In order to figure out your personal rate of return, you need to add in the purchase dates. The easiest way to do this is with Excel’s XIRR function. I ran the function myself. Here are the results:

So, according to those numbers, you’re personal rate of return is -22.68%, which is an annualized number. Sounds scary but keep in mind that it wouldn’t take much of a rise in the price of VFINX for that number to become positive. I was playing around with the numbers and figured out that if VFINX went up to $125, you would actually have a positive personal ROR even though the fund would still be down over 7.51% for year.

So, even though it stinks to watch your periodic investments drop in value, in the long run, it’s a good thing if you’re dollar-cost averaging.

14 responses to Don’t Give up on Dollar-Cost Averaging!

  1. Dollar cost averaging is a very good way to invest. Now the market is having a sale.

  2. yeah, but the same works the other way in an up market…

  3. js,

    That may be true, BUT dollar-cost averaging is the only way for most people to invest.

  4. Great post, JLP. Maybe I have bunker mentality, but I refuse to let my emotions scare me into rash, foolish decisions. It can be painful, but I will not take my money & run to safe, low risk investments. DCA is my tool vehicle for regular, disciplined investing, and right now there’s a nice sale. I throw extra money in when I can during a down market (only if my emergency funds can spare it), but DCA is my primary method.

    When nerve rattling times like these hit (and I’m old enough to have weathered a few), I turn off the tv and the white noise, and I pull out my financial books – Four Pillars of Investing, The Millionaire Next Door, John Bogle’s books, etc. The wisdom in those books helps to reassure me that I am on the right path.

  5. nice scheme. The problem is, the investment advisers don’t call for dollar cost devesting while the market is rising.
    To make things worse, the market will crash anytime!

  6. “nice scheme. The problem is, the investment advisers don’t call for dollar cost devesting while the market is rising.”

    Perhaps they don’t, but any advisor worth anything will encourage rebalancing. A balanced account with other asset classes would not have seen the same drop as an account solely invested in the S&P 500.

    People do in fact tend to do dollar cost devesting when they come to retirement age. That is, they tend to take regular distributions over time.

    Personally, I’ve made this observation. Dollar cost purchases get you in at the harmonic mean of the market price. The harmonic mean is smaller than the usual “average” most of us are familiar with. All other things being equal getting in at the harmonic mean and out at the arithmetic mean would be a good thing. It could be better to cash out, not in equal dollar amounts, but in percentage amounts.

    Perhaps something to think about. Perhaps not.

  7. Don,

    I think it’s Wilson’s mission to refute ANYTHING I say on this blog.

    Wilson,

    Are you familiar with the concept of asset allocation and rebalancing? By rebalancing, you are selling off those positions that have risen (devesting) and purchasing more of those that fell behind in the allocation.

  8. Then again, if the price went from $111.94 to $125, that’s an 11.6% increase by my calculations. Possible? Yes. Overnight? No.

    Of course if you kept on DCA while prices are lower then the price it needs to go to to get you in the black is smaller.

  9. JLP: you are permabull. You don’t know what’s happening to this world:)

  10. Wilson said:

    “JLP: you are permabull. You don’t know what’s happening to this world:)”

    No, I’m not a permabull. I do think that over the long run, the market will trend up and not down. That doesn’t make me a permabull. I realize that we could have long stretches of time when the market does poorly.

    I’m still trying to figure out what you are.

  11. Average Schlub July 22, 2008 at 12:26 pm

    I’m certainly familiar with DCA as an investment system and I’ve been led to believe it’s merits. I think the only alternative is to time the market and that has an elusive endeavor for myself. What I don’t understand in your example is how your personal rate of return could be any worse than the YTD performance seeing as how the highest price was at the start of the year and the lowest price at the end. If you DCA’d then you bought some shares at prices in between so there’s no way it could be worse than an initial $7000 investment at $135. You sure you ran that Excel function correctly?

  12. Average Schlub,

    Keep in mind that the XIRR function is an annualized number. If you annualize -14.04%, it becomes -23.71%.

    [(1 – .1404)1/(204/365)] – 1

    [.85961/(0.55890411)] – 1

    [.85961.79] – 1

    0.7629 – 1

    -.2371 or -23.71%

  13. I believe that research has shown DCA to be less effective than full investment the majority of the time. There is nothing special, and quite the opposite, about DCA on its own. The ‘real’ advantage to DCA comes down to investing as much as possible as soon as possible (always assuming that the investment averages positive), not in spacing out your investments.

    Likewise, you shouldn’t stop investing at any point – not because of DCA, but because you want to be fully invested as soon as possible.

  14. Hi JLP, sorry to dig up this old post/thread. I was doing some Google searches and I found your blog (nice!). If I can ask a few basic questions (warning: I’m an investing newbie). In your reply to “Average Schlub” you mention the numbers “-14.04%” and divide “204 by 365”. May I ask where did you get those numbers from. When I look at the example/illustration you worked out in the main part of the post, I don’t see these numbers anywhere. I am basically trying to understand why your DCA Annualised return of -22.68% is worse than a lump sum return (111.94-135.15)/135.15= -17.17%. I am sure I am doing my sums wrong. Can you kindly correct me? I’ll learn a lot. I’ve already learnt a lot from your site. Many thanks