DATAQUEST (2024)

I am a strong believer in the advantages of DCA (dollar-cost-averaging).I recommend it to anyone making a substantial move from cash to mutualstock funds (unless they fancy themselves to be market-timers). In particular,if you have recently received an inheritance that increases your worthby over 50%, you should use DCA instead of putting it all in at once. Ifyou have a large amount of money that you know you really ought to putinto the stock market but you can't bring yourself to do it because youare afraid the market is too high, you should use DCA for 12 months insteadof waiting.

However, I find that using DCA for any period longer than 12 months isa bad strategy. It may even be a good idea to DCA over a period as shortas 6 months; the choice depends on an individual's balance between riskand return (6 months is a little more risky and a little more profitablein the long run).

I compare two alternative strategies: LUMP-SUM, where you move a substantialamount of money from your money market account to a mutual stock fund today,and DCA-N, where you move one Nth of that substantial amount at the beginningof each of N months starting today. I give historical data to support myconclusions, and I present a full analysis for DCA-6, DCA-12, DCA-18, DCA-24,and DCA-36 in the appendix.

The Logic

DCA is not for people who consider themselves competent market-timers.Market-timers lump-sum in at whatever time they judge that the market isvery likely to go up in the near future. And they get back out of the marketwhen they judge that the market is very likely to go down in the near future.The DCA choice is for people who fear that the market may drop drasticallyat any time, but do not feel competent to judge whether that is more orless likely now than at some other time.

I feel that the purpose of DCA is to avoid the damage from a substantialdrop happening in the first few months after a lump-sum investment. 6-monthDCA works fine if the drop happens in the first two or three months, becausehalf of the money is invested at a lower cost. But DCA-6 is not effectiveif the drop happens in the fifth or sixth month. 12-month DCA gives goodresults for drops that happen in the first 7 or 8 months. My feeling isthat, beyond that point, there is generally no substantial problem anyway,because when a drop does not happen for say 8 months, the market usuallyrises enough in those first 8 months that the net result is a gain.

An additional point is that, if you use say a 24-month DCA period in aparticular instance and it is successful, i.e., the stock market fallssignificantly in the first 6 months, then the loss is more often than notmade up in the following 6 months. But that means that the last half ofthe money is being DCAd into the market at ever high prices. The operationis a success but the patient dies. Your caution is vindicated but you loseanyway. Logically, then, DCA should not be used over periods of 2 or 3years, not even 18 months. A DCA period between 6 and 12 months is probablybest.

Historical Support for DCA-6 Versus DCA-36

But all of the above is theoretical, a subjective opinion based on vagueconcepts of how stock markets behave. It is helpful to look at some concretehistorical data to see how various periods would have turned out. For this,I need a well-defined process for investing. I implement e.g. DCA-12 asfollows: Move 1/12 of the assets into the stock market on the first dayof the first month and let the rest stay in the money market. One monthlater, move 1/11 of the remaining money market balance into the stock market,etc., for 12 months.

Equivalently: Divide the initial amount into N equal parts. Move the firstpart in immediately. Let the second part sit in the money-market for onemonth and then move it plus its interest into the stock market. Let thethird part sit in the money-market for two months and then move it plusits interest into the stock market; etc. Thus the amounts moved in aresteadily increasing in nominal dollars, but they are equal in time-value-adjustedterms.

Question: How do we measure the RISK against which we are insuring by DCA?I figure that the main thing to avoid is lump-summing an amount into thestock market and finding out some months later that its value is LESS thanwe started with. Normally, if we move $10,000 into the stock market ina lump-sum, then we hope to have $11,000 or $12,000 one year later. Ifwe have $10,500, that isn't bad; we would have had the same in a moneymarket. If we have just $10,000, that is disappointing and irritating,but we knew that stock investing wasn't a sure thing. Panic, depression,anger, and regret set in only if we actually have significantly less innominal dollar terms than we started with.

For DCA-36, I looked at the 493 rolling 36-month periods within the 44years 1953-1996. I calculated that each use of DCA-36 cost on average 7.40%of total assets compared with lump-summing (computed using the geometricmean, as is normal for computing returns). That is not 7.40% per year for3 years, but 7.40% for the one decision to use DCA-36 instead of lump-summing.

But the cost is not the only consideration. We have to consider the RISKof severe loss. Note: Stock market returns in the following are based ontotal returns of the S&P500 including reinvested dividends. Money marketreturns are estimated using 3-month treasuries, to adjust for interestearned on the money not yet moved into the stock market using DCA. Thestock market earned slightly over 5% more per year on the average in this44-year period; the average dollar in DCA-36 is kept out of the marketfor 17.5 months, almost 1.5 years, so of course lump-summing beats DCA-36by roughly 1.5 times 5%.

Unfortunately, there is no really good single number to measure the risk.We all know how unsatisfactory the standard deviation is as a measure ofthe risk involved in investing in stocks. So the following provides enoughstatistics to let you make your own decision as to the risks and rewardsand costs involved in DCA.

There were only 30 of those 493 DCA-36 cases where a lump-sum had lessat the end of 36 months than at the beginning. We want to ameliorate those30 cases. But it doesn't help to DCA in those disastrous cases if DCA doesn'tmake it BETTER. So, I set the criterion of effectiveness that DCA shouldproduce results at least 5% better than lump-summing in cases where lump-summingloses money, otherwise it does not offer much protection.

In the 30 cases where lump-summing lost money over 36 months, DCA-36 cameout more than 5% better than lump-summing in only 16. Those 30 are easyto categorize: 7 began on 5/1/67 through 11/1/67; 1 of the 30 began on12/1/68; The other 22 began on 5/1/71 through 2/1/73 (all periods starton the first-of-the-month). Note that the S&P500 lost 25.2% in the3 months July-Sept 1974.

In the 22 cases involving 1974 where lump-summing lost money, DCA-36 didn'thelp much for the first 8 of those periods (it was WORSE in 6 cases, 0.2%and 2.1% better in 2 cases), came out 7.7% to 18.4% better for the next8 periods, and came out 20.8% to 27.5% better than lump-summing for thelast 6 of the 22 periods.

That is not a very effective insurance policy, considering the premium:an average loss of 7.40% of total assets for each use of DCA-36 insteadof lump-summing. 14 of the 16 "effective" cases included thesummer of 1974; the other two began 10/67 when lump-summing lost only 3.33%and 12/68 when lump-summing lost only 3.97%. In other words, DCA-36 isa moderately effective way of guarding against a re-occurrence of the summerof 1974 and is pretty much useless otherwise.

But the main problem is that most of the time DCA-36 doesn't even do whatpeople expect of a DCA strategy: If you DCA-36 and the market tanks inthe first 3 or 6 months, sure, you get to gloat that the lump-summer tooka 15% loss and you didn't. Then for the next 30 months, you gradually feedpiddling little amounts into the market while the lump-summer is makingmoney hand-over-fist. Then when you are completely in, the market tanksagain. Is that insurance???

Matters are quite different for DCA-6. I looked at the 523 rolling 6-monthperiods within the 44 years 1953-1996. Lump-summing came out only 1.11%better on average than DCA-6 (per use of DCA-6, not per year). DCA-6 cameout better than lump-summing in 199 of the 523 cases. But that is not thepoint. We have to consider the RISK of severe loss.

There were 143 cases where a lump-summer had less at the end of 6 monthsthan at the beginning. We want to ameliorate those 143 cases. In 122 ofthem, DCA-6 came out better than lump-summing. There were only 56 of the523 cases in which DCA-6 came out more than 5% better than lump-summing,but 55 of those were cases where lump-summing lost money. So DCA-6 helpsmost where it is most needed.

Of the 32 cases where lump-summing lost over 10%, DCA-6 did better in 30of them; in fact, in 26 of them, DCA-6 did more than 5% better. And ineach of the 3 cases where lump-summing lost over 20%, DCA-6 did 6 to 11%better.

Conclusions

DCA-6 offers some significant protection against lump-summing into thestock market and losing more than 10% in the next 6 months, and it is ata small cost (1.11%). However, since there were only 15 cases in whichDCA-6 gave at least 10% more than lump-summing, and in the best case gavejust 19.9% more, you are in effect paying a 1.11% premium for an insurancepolicy that will only pay off well (10 to 20%) 3% of the time. Those arenot really great odds.

The payoff is higher for a 12-month period of DCA. Lump-summing lost moneyin 114 12-month periods, and DCA-12 beat lump-summing in 100 of them, 64by more than 5%. DCA-12 sometimes beat lump-summing by over 20%. Therewere 40 12-month periods where lump-summing lost over 10%; DCA-12 beatlump-summing in 39 of those 40. The only drawback is that each use of DCA-12costs you an average of 2.50% of what you would have if you lump-summed;in general, you come out ahead when lump-summing loses, but gain less whenlump-summing wins. But that is what you expect when you dollar-cost-averageanyway.

Since I defined effectiveness as meaning that DCA beats lump-summing bymore than 5% in those instances where lump-summing loses money, we have:DCA-6 is effective in 55 of 143 cases; DCA-12 is effective in 64 of 114cases; DCA-18 is effective in 46 of 77 cases; DCA-24 is effective in 31of 45 cases; and DCA-36 is effective in 16 of 30 cases. Thus DCA-12 clearlyproduces the highest number of effective cases, but DCA-6 costs half asmuch and produces the second-highest number of effective cases.

NOTE 1: These results imply that the best timing for people who DCA quarterlyis that the last of N equal quarterly payments should be made 6 to 12 monthsafter the first. Thus there should be 3 to 5 equal quarterly payments.NOTE 2: If you DCA into a stock fund with a few hundred dollars a monthfrom your paycheck over a period of many years, because that is all youcan afford to save, that is DCA perforce and not something that the aboveanalysis contra-indicates. Personally, I prefer to save it up in a short-termbond fund that I empty once each 6 months, because it simplifies my book-keeping;but I know that slightly reduces my returns vis-a-vis DCA. NOTE 3: DCAis only valuable for moving from cash or bonds into stocks. If you aremoving from one stock investment to another, DCA is pointless, becausethe chances of moving in to a market top are the same as the chances ofmoving out from a market top, so the risks balance out. On the other hand,it doesn't hurt either.

My conclusion is that DCA for 6 to 12 months is the most that one shoulduse, and then only if moving more than 5% of your total assets (since eventhe worst case would cut your overall total returns by only 1% or so).If you are shifting 30% or more of your total assets from cash to stock,you could take up to but no more than 18 months; this once-in-a-lifetimesort of situation merits overly-excessive caution. But I provide the databelow on which you can base your own opinion.

Appendix (uniform presentation for 5 different timeperiods)

DCA-6 beat lump-summing 199 of the 523 instances; the lump-summer gained1.11% on average. Of the 143 instances where lump-summing lost money, DCA-6beat lump-summing 122 times, 55 of them by at least 5%, and 15 of themby at least 10%. Of the 32 instances where lump-summing lost more than10%, DCA-6 beat lump-summing 30 times, 26 of them by at least 5%, and 11of them by at least 10%. Of the 3 instances where lump-summing lost over20%, DCA-6 did 6.0% (1/62), 9.0% (3/74), and 11.2% (4/74) better. The 6biggest relative gains for DCA-6 were 13.6% (5/74), 13.6% (6/74), 15.1%(7/74), 13.5% (8/87), 19.3% (9/87), and 19.7% (10/87) more than lump-summing.

DCA-12 beat lump-summing 175 of the 517 instances; the lump-summer gained2.50% on average. Of the 114 instances where lump-summing lost money, DCA-12beat lump-summing 100 times, 64 of them by at least 5%, and 30 of themby at least 10%. Of the 40 instances where lump-summing lost more than10%, DCA-12 beat lump-summing 39 times, 34 of them by at least 5%, and20 of them by at least 10%. Of the 8 instances where lump-summing lostmore than 20%, DCA-12 beat lump-summing every time, all of them by morethan 5%, and 7 of them by more than 10%. The 6 biggest relative gains forDCA-12 were 20.9% (11/73), 18.6% (2/74), 19.9% (3/74), 18.7% (4/74), 20.1%(9/87), and 19.4% (10/87) more than lump-summing.

DCA-18 beat lump-summing 170 of the 511 instances; the lump-summer gained3.84% on average. Of the 77 instances where lump-summing lost money, DCA-18beat lump-summing 69 times, 46 of them by at least 5%, and 33 of them byat least 10%. Of the 27 instances where lump-summing lost more than 10%,DCA-18 beat lump-summing all 27 times, 26 of them by at least 5%, and 22of them by at least 10%. Of the 12 instances where lump-summing lost morethan 20%, DCA-18 beat lump-summing every time, all of them by more than12%. The 6 biggest relative gains for DCA-18 were 22.5% (8/73), 21.0% (9/73),24.7% (10/73), 25.4% (11/73), 18.2% (9/87), and 19.7% (10/87) more thanlump-summing. DCA-24 beat lump-summing 158 of the 505 instances; the lump-summergained 5.06% on average. Of the 45 instances where lump-summing lost money,DCA-24 beat lump-summing 39 times, 31 of them by at least 5%, and 21 ofthem by at least 10%. Of the 24 instances where lump-summing lost morethan 10%, DCA-24 beat lump-summing every time, 21 of them by at least 5%,and 15 of them by at least 10%. Of the 9 instances where lump-summing lostmore than 20%, DCA-24 beat lump-summing every time, all of them by at least5%, and 7 of them by at least 10%. The 6 biggest relative gains for DCA-24were 24.0% (1/73), 24.4% (2/73), 23.7% (4/73), 23.2% (8/73), 24.1% (10/73),and 24.5% (11/73) more than lump-summing. 9/87 had a gain of 17.6% and10/87 had a gain of 15.4% more than lump-summing.

DCA-36 beat lump-summing 127 of the 493 instances; the lump-summer gained7.40% on average. Of the 30 instances where lump-summing lost money, DCA-36beat lump-summing 22 times, 16 of them by at least 5%, and 14 of them byat least 10%. Of the 14 instances where lump-summing lost more than 10%,DCA-36 beat lump-summing 10 times, 9 of them by at least 5%, and 8 of themby at least 10%. Of the 2 instances where lump-summing lost more than 20%,DCA-36 beat lump-summing only once, by 7.7%. The 6 biggest relative gainsfor DCA-36 were 22.2%, 26.2%, 27.5%, 26.6%, 24.1%, and 24.1% more thanlump-summing for the 6 periods beginning 11/72 through 4/73, respectively.9/87 had a gain of 13.7% and 10/87 had a gain of 11.6% more than lump-summing.

Alternative Criterion

We could use an alternative definition of effectiveness based on the amountof protection provided in the worst 50 cases (out of the 500 or so, thusroughly 10% of cases). Here are the results: