Snapshot - Markets

30 years of ‘dollar cost averaging’: does it work?

Schroders calculations show how money drip fed into the market could provide some protection against volatility but lump sum investing has tended to provide better returns over the long term.

25/04/2019

David Brett

David Brett

Investment Writer

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The last three decades have shown just how volatile financial markets can be. After the boom of the 1990s came the dotcom crash at the turn of the millennium. This was followed by a mini recovery before the financial crisis struck, in 2008. It’s been a bumpy ride for investors.

The ups and downs of the market can make deciding when to invest extremely difficult. While there might never be a perfect time, Schroders calculations show that “dollar cost averaging” is a strategy that could help smooth out returns, particularly when markets are volatile.

What is dollar cost averaging?

Dollar cost averaging (or pound cost averaging if you are in the UK) is simply an investment strategy that involves making smaller, regular, investments, perhaps on a monthly basis, in preference to investing all in one go (a lump sum). Many people will already be doing this, for instance if they have a personal pension.

By drip feeding their cash into the market investors make purchases at intervals. Theoretically, that means they are buying assets at different prices, which potentially smooths out the more extreme highs and lows that could be experienced if all the money was invested at once. It also means that if markets begin to fall precipitously there is the option to stop investing entirely.

Take the period during the global financial crisis as an example. Schroders calculations, as illustrated in the chart below, show that had you been unfortunate enough to begin investing on 1 January 2008 and invested a lump sum of $1,200 (the orange coloured line) into the MSCI World Total Return Index, which includes dividend payments, 12 months later your investment would be worth $716. A loss of 40%.

However, if you had split your lump sum investment into 12 equal instalments of $100 each (the blue coloured line), the value of your investments would still have fallen but not by nearly as much. By 1 January 2009 your investment would have been worth $867. A loss of 28%.

Dollar cost averaging vs lump sum investing during the financial crisis

 

Past performance is not a guide to future performance. The value of investments and the income from them can go down as well as up and investors may not get back the amounts originally invested.

Source: Schroders. Refinitiv data for the MSCI World Index - total return correct as at 31 March 2019. The material is not intended to provide advice of any kind. Information herein is believed to be reliable but Schroders does not warrant its completeness or accuracy.

Taking a longer example, the chart below illustrates the returns on $100 (blue coloured line) invested at monthly intervals in the MSCI World Total Return Index but over 31 years, between 1 January 1988 and 1 January 2019.

We compare it to the returns on $37,200 (orange coloured line), which is the equivalent of 31 years of $100 monthly payments, invested in one lump sum on 1 January 1988 and left alone until 1 January 2019.

According to Schroders calculations, the lump sum investment could now be worth $350,000, or an annual return of 7.5%.

The same amount invested incrementally over the same 31 years might now be worth $123,395, or an annual return 3.9%.

None of these figures have been adjusted for inflation or charges. Of course, past performance is not a guide to future performance and may not be repeated.

Dollar cost averaging vs lump sum investing since 1988

 

Past performance is not a guide to future performance. The value of investments and the income from them can go down as well as up and investors may not get back the amounts originally invested.

Source: Schroders. Refinitiv data for the MSCI World Index - total return correct as at 31 March 2019. The material is not intended to provide advice of any kind. Information herein is believed to be reliable but Schroders does not warrant its completeness or accuracy.

The risk and rewards of lump sum investing

The data illustrates the old market adage that the more you are able to invest and the earlier you are able to invest it, the bigger the potential rewards, providing you are able to give the investment the time to grow.

However, investing the entire amount in one go comes at a risk. Imagine for a moment how you would have felt if you had made that $37,200 investment in Jan 2008 and seen it fall to little more than $20,000 by December 2008. Would you have felt comfortable leaving your money invested?

Hindsight is a wonderful thing. It is easy to see now that had you stayed invested you would have reaped healthy returns, but at the time could you have watched and not intervened as markets were crashing? 

Claire Walsh, Schroders Personal Finance Director, has first hand experience of having to make the choice between lump sum investing and drip feeding money into the market.

“There are psychological drivers which we are all subject to, which the investment industry terms 'behavioural finance'. Crucially, investors want to avoid losses and have smoother returns,” she said.

“Whilst you cannot predict what markets will do, you can think about how you would feel if say, markets are crashing? Would you see the losses as a buying opportunity or would you want to get out and into cash?

“I can personally attest to this.  Despite knowing that investing as much as I could, as early as possible, should reap greater rewards, I still opted to phase my money in, because I am only human. I know that I would feel dreadful if I saw the value of my investments go down in the early days.

“Fluctuating markets are distressing for most people. Cost averaging can give investors greater peace of mind and stop them from selling at the bottom and buying at the top.”

Three potential benefits of dollar cost averaging

Dollar cost averaging does not always deliver the most profitable return but it does have its benefits:

1. Regular savings

Not many of us have the luxury of being able to invest a large lump sum. Dollar cost averaging can get investors into the habit of saving money on regular basis.

2. Reduces risk

By investing smaller amounts, on a regular basis, you are less exposed to entering the market at extremely high or low valuation levels. That’s because you are buying shares at different price levels. Over time this helps to smooth out the average price.

3. Takes advantage of falling markets

Theoretically dollar cost averaging works better in a falling market because you are purchasing shares at a lower price, which means you can afford to buy more.

Over the long term, investing the entire amount as early as possible could provide higher returns.

However, given what we know of our tendency to be loss averse, even when there is an intention to keep our money invested for a number of years, there is a strong case for dollar cost averaging during periods of market uncertainty. This is because the approach provides more protection from volatile market moves.