Dollar cost averagin (DCA) is a controlled way to participate in the stock market. Today, an easy and cost effective investment scheme using Exchange Traded Funds (ETFs). All you need to do is install a plan with your online broker: E.g. investing 25$ a month into an S&P ETF. As Benjamin Graham put it in "The intelligent investor": Buying stocks using cost averaging will reward you with an average market performance. No more but not less either. An important statement considering that stocks are on of the most secure investments in the long run.
With public debts rising, reserve banks printing ever more money and stock markets reaching new all time highs, the risk of a down turn increases. So how good does DCA performe during a market downturn?
The 1929 bear market as blue print
I looked at the 1929 US bear market to answer this question. During the 1929 recession the dow jones dropped by staggering 90% over a period of 2.5 years. On the other hand, it took 25 years for the Dow Jones to reach its pre crisis value.
Using the same data source as in Taxes, inflation and the stock market, I created three scenarios:
- Dow Jones year end prices and dividends
- Linear approximation of above scenario including a 3% yearly dividend yield
- The linear model with a 95% performance drop
The chart on the right displays these three scenarios while the underlying can be found in the excel file attached to this article.
Performance of these three scenarios over 25 years is shown in the following table.
|Scenario||25 years w/o dividends||25 years dividends reinvested|
|Total return||% p.a.||Total return||% p.a.|
All three scenarios show a positive return even after taking inflation into account which was at 150% after 25 years. Very interesting to see is, the deeper the fall, the higher your return as you are able to buy more shares when the price for the index is down. Leveraging this effect by increasing the investment 2 to 3 times after the index has fallen about 50%, will increase your return by addtional 20 to 50%. You can find this scenario in the excel file as well. Of course the numbers assumes you are able and psychologically capable to endure the downturn. Seeing your fortune shrinking ever faster and instead of selling continuing to poor money into your account may seem logically but surely is no easy feat.
In short: The worse the downturn the better DCA will perform as long as you are able to invest the same amount on a regular basis. Even better when you are able to increase your regular investment.
Disclaimer: This article soely shows my own oppinion and must not be taken as investment advice.