Dollar Cost Averaging, Does It Work in Today’s Turbulent Stock Markets?

Oct. 18, 2010 - PRLog -- The United States stock indices have fallen dramatically from October 2007 when both the Dow Jones Industrial Average (the Dow) and the S&P 500 had reached all time highs. By March 2009, the Dow had lost 54.9 percent of its value; the S&P 500 57.7 percent; and the NASDAQ Composite (the NASDAQ) 55.8 percent. Since their nadir, the Dow had increased by 60.6 percent in November 2009; the S&P 500 64.3 percent; and the NASDAQ 69.5 percent. Despite these dramatic increases, investors in the Dow had still lost 27.6 percent since October 2007; in the S&P 500 30.5 percent; and in the NASDAQ 25.1 percent. Investor dysphoria had turned to euphoria in less than a year. The question facing investors is whether to increase their exposure to equities or to reallocate their holdings to other assets classes such as fixed income instruments, certificates of deposit, real estate, commodities, etc. Were investor perceptions irrational at their nadir or at their zenith? The answer is that both were probably irrational. The equity markets did not further deteriorate further from their 2007 low and the markets will most likely not increase at comparable rates as they have recently. When markets experience recent gains, many investors commit funds. Yet when markets have experienced losses many investors are afraid to commit funds. Instead of buying low and selling high, they, in their attempts to buy high and sell higher, often end up buying high and selling low.
   Dollar Cost Averaging is a technique that calls for investing equal amounts of money periodically rather than investing all funds at a single time. To test the validity of this technique let us compare two investors each of which had $2,600 to invest in October 2007.
•   Investor A invests his $2,600 in the Dow Jones Industrial Average. At the end of November 2009, his investment has been reduced to $1,885, a loss of 2.2 percent.
•   Investor B decides to invest $100 at the end of each month in the Dow. At the end of the same period, his investment is worth $2,670, 41.8 percent than Investor B.
Similar investment strategies on the parts of Investors A and B reveal that an investment in the S&P 500 would be worth 46 percent more than B’s; in the NASDAQ Composite 43.3 percent more than B’s.
   If one were able to consistently identify market tops and bottoms, then this would be the optimal strategy. Losses would be avoided and gains maximized. However, no investor is always infallible. For those of us, the investment mortals, Dollar Cost Averaging is a technique worthy of consideration when contemplating an investment.