Is Dollar-Cost Averaging the Cure for Market Jitters?

Seth J. Masters

The US stock market is at record highs, and warnings of a downturn are loud and shrill on every side. Even if you’re convinced you should own more stock, you may find it difficult to buy now. What if you invest your money and the market suddenly drops?

If this fear is holding you back, dollar-cost averaging could help. Dollar-cost averaging involves investing systematically over a period of time to diversify the timing of your entry into the market. It’s tiptoeing into the market rather than plunging right in. How do the results of these two strategies compare?

The Facts

To find out, we conducted a historical analysis of the US stock market since 1926. This period encompasses more than 1,000 different entry points across a wide range of market environments, from the Great Depression to the bull markets of the 1980s and 1990s and to the global financial crisis in 2008.

Statistically speaking, investing all at once has been the best strategy for maximizing returns (Display 1). The average stock market gain in all rolling 12-month periods since 1926 was 12.2%, while the average result of staying in cash was only 3.6%. Dollar-cost averaging with fixed monthly installments delivered average returns of 8.1% across all the rolling 12-month periods—much better than holding cash but more than 4% worse than investing immediately. That’s because stock markets tend to rise over time, so investing immediately wins on average.

Historically, Investing Immediately has maximized returns

Benefits and Costs

Just because the statistics favor investing immediately doesn’t make it the best strategy for everyone. Dollar-cost averaging has a nonmonetary value, too:  It can help you sleep at night. You might think of it as a kind of insurance against the regret you’d feel from a steep market drop right after you invested. Of course, another way to insure against this regret is simply to stay in cash. We examined both strategies to see how much each type of “regret insurance” would cost.

Once again, we analyzed stock market data for each 12-month rolling period from 1926 through 2013. We divided these periods into quintiles, from the strongest to the weakest. The bottom quintile included years as bad as 2008; the top quintile included years as good as 1954, when the S&P 500 rose 53%.

We found that in very poor markets—which occurred 20% of the time—dollar-cost averaging helped preserve capital and resulted in 10% more wealth than investing all at once, but staying in cash was more than twice as protective (Display 2). The other 80% of the time, both dollar-cost averaging and holding cash hurt performance. The question is how much.

 Comparing the costs of Regret Insurance Strategies

In typical markets (the three middle quintiles), you’d have foregone 3.9% with dollar-cost averaging and 9% by staying in cash. The costs were even higher in strong markets, where dollar-cost averaging produced 19.1% less wealth, and staying in cash cost fully 37.8%.

Seen in this light, holding cash is risky relative to being at your target exposure to stocks. Dollar-cost averaging is a way to smooth out timing risk and moderate the potential cost. Whether you decide to dollar-cost average depends on how you weigh the better outcomes in poor markets against the weaker results in typical and strong markets.

If you decide to dollar-cost average, it’s important not to lose your nerve if the market drops after the first few installments. The biggest risk with any investment strategy is the temptation to abandon the strategy and wait in cash.  As we’ve seen, going to cash has generally produced the weakest returns. Instead, it helps to remind yourself that dollar-cost averaging just saved you money compared to jumping in all at once, and stick to your systematic investment rule.

In the long run, you’re likely to do best by jumping into the market with both feet. If you’ve been stuck on the sidelines, dollar-cost averaging may help to overcome your market jitters. Either way, the key to achieving your long-term financial objectives is to get to your strategic asset allocation and stay there.

Past performance does not guarantee future returns. The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AllianceBernstein portfolio management teams.

Seth J. Masters is Chief Investment Officer of Bernstein Global Wealth Management, a unit of AllianceBernstein L.P. (NYSE: AB)

4 comments

  1. Mr.Masters,

    I cannot find the period for your dca. For example, did you invest $10,000 immediately vs dca the money over a period . . .maybe 12 months? Or did you dca the $10,000 over the entire period selected . . .say 30 years?

    In my work, I”ll oftentimes dca a large sum over 12 months.

    Thoughts?

    Thank you for this study.

    Tim Medley

    • Seth Masters

      Mr. Medley,

      In the case study presented in the blog, we define dollar-cost averaging into the S&P 500 as level monthly investments over 12 consecutive months, with the balance held in cash. Thus, the portfolio is initially 1/12th stock and 11/12ths cash, the next month it’s 2/12ths stock and 10/12ths cash, and so on.

      Although we didn’t discuss it in the blog, we have also studied the optimal period for dollar-cost averaging. We found that the longer you take to average in, the higher the cost and (up to a point) the greater the potential to minimize regret risk. Dollar-cost averaging over periods of up to six months provides significant regret minimization benefits with relatively modest cost.Between six and 12 months, the trade-off between benefit and cost becomes a bit less favorable. If you dollar-cost average over more than 12 months, there is little increased benefit for a much higher cost.

      We conclude that averaging in for six months or less offers the best trade-off between cost and benefit. But risk-averse investors who are willing to pay an increased premium for extra protection – the target audience for the blog – might prefer to extend the strategy as long as 12 months. Beyond that point, our analysis indicates that averaging in is not worthwhile.

      Seth Masters

  2. Neal Griffin

    This is interesting, but immediate investing vs all cash are good for everyone while dollar cost is only available to someone who has both the availability of free cash to invest, and the discipline to do it. Most people rarely invest for the long run until they reach mid life,following the kids graduation from colleges. So there is a generational issue and I suspect that each 10, 15 or 20 yr periods might produce something different because their investing period would terminate after say 20 period. Thus, from your model there are probably 85 individual periods what if there were only 20 year periods rather than 1 would this look different. Anyway it”s just a thought

    • Seth Masters

      Neal:
      If I understand you correctly, you’re wondering if dollar-cost averaging would be advisable for an investor with a medium time-horizon (such as 20 years) rather than someone with a lifetime to invest.
      You are right that the shorter the investment horizon, the greater the potential cost in terms of final wealth. To take an extreme example, if your investment horizon is just two years and you average in for one of them, you’ll be just 50% invested in stocks on average during the course of year 1 and 100% in year 2 — so that in a rising market you’ll only benefit from roughly 75% of the two-year total gain. If you have a 20-year investment horizon, you’ll end up with 19 years of full exposure to stocks, which will bring your participation in the market””s total gain to almost 98%. And if your horizon is longer than that, you’ll get ever closer to 100% participation as time unfolds.
      So, in this sense, the shorter your time-frame, the greater the urgency to become fully invested, because that way, you get 100% participation right from the start.

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