Activity Idea: How Does Dollar Cost Averaging Work?
One of the pieces of advice that Warren Buffett gives Lebron James is that he should invest by putting a fixed amount in index funds every month. Also known as dollar-cost averaging, this process allows investors to buy more shares when prices are low and fewer shares when prices are high, thereby mitigating the risk of “buying high and selling low.” 401(k)s, which involve investing a percentage of your paycheck every pay period into an investment vehicle, provides an example of dollar-cost averaging.
I thought it would be interesting to see how such a strategy (investing a fixed dollar amount every month) would have fared during the eleven year period from 1999-2009. Why did I choose that period? It had two remarkable market declines (42% drop from ’00-’03 and 50% decline from ’07-’09 based on monthly closing prices for S&P500). It would have been hard to pick a more challenging period to invest which is why I found it interesting to run a dollar-cost average simulation.
I created a spreadsheet (DollarCostAverageExample) to run this simulation and show how what this strategy looks like:
- Got historical prices for the S&P500 (ticker: SPY) from January 1, 1999 to December 31, 2009 from Yahoo Finance; used Adjusted Price (which takes into account dividends)
- Assumed that investor invested $100/month based on price at the beginning of that month. So, on 1/4/1999, the investor purchased 1.04 shares of SPY at $95.81. Every month thereafter, the investor invests $100 and adds to his/her share count (column L) based on the price on the first trading day of the month.
- I created an analysis (column N, O, P) to track whether the value of the investor’s shares was less than or greater than the amount he/she had invested.
What takeaways can be gleaned by running this analysis:
- Despite this period of time with major market tumult, the investor would have suffered a slight loss of about $400 when comparing invested capital ($13,200) vs. market value of investment ($12,813) at the end of 2009. In the context of these two sharp downdrafts that tested most investors’ mettle, this is not a bad outcome.
- In fact, five years later, the shares owned at the end of 2009 would have more than doubled so if the investor could have just hung on during this challenging period, they would have been rewarded.
- Dollar cost averaging worked as it should have by having the investor buy more shares when prices were low and fewer shares when prices were high.
- If given a choice (which you won’t have), you would prefer to have the big market decline occur early in your investment life (when your balances are low) rather than late (when your balances are high and you might be close/in retirement). Hence, the standard investment advice to become more conservative as you near retirement by reducing your stock exposure.
About the Author
Tim's saving habits started at seven when a neighbor with a broken hip gave him a dog walking job. Her recovery, which took almost a year, resulted in Tim getting to know the bank tellers quite well (and accumulating a savings account balance of over $300!). His recent entrepreneurial adventures have included driving a shredding truck, analyzing executive compensation packages for Fortune 500 companies and helping families make better college financing decisions. After volunteering in 2010 to create and teach a personal finance program at Eastside College Prep in East Palo Alto, Tim saw firsthand the impact of an engaging and activity-based curriculum, which inspired him to start a new non-profit, Next Gen Personal Finance.