Whatever investments your portfolio comprises, dollar cost averaging (DCA) is a useful strategy for minimizing asset purchases when the market is overvalued. DCA allows you to invest equal dollar amounts at regular intervals (monthly, quarterly) regardless of the current market conditions. In this way you buy more shares, bonds, etc. when the market is oversold (cheaper), and fewer shares when the market is overbought (more expensive).
DCA does not guarantee that you will make money however. If you are buying into a secular (long-term) bear market, or even into a trading-range market, you may lose money, or make no money. As an example, let's look at the S&P 500 Index over the past fifteen years, from September, 1996 to September, 2011.
The following chart shows the monthly adjusted close prices for the S&P 500 Index (Yahoo! Finance symbol ^GSPC) between September, 1996 (687.33) and September, 2011 (1154.23). The average index price over this 15-year period is 1160, and the standard deviation is 200. The average price plus/minus one standard deviation (960 to 1360) is shown as the blue shaded rectangle. This means that 67% of the monthly prices fall within this range. NOTE: The large size of the standard deviation reflects the high volatility of the index during this fifteen-year period.
There are 180 months in this fifteen year period. Let's say your investment plan is to invest $1000 each month in the S&P 500 Index, and you have faithfully followed that plan over the past fifteen years. You would have bought $1000 worth of index shares each month... fewer shares when the index was expensive, and more shares when the index was cheaper. Let's see how you would have done:
Index Starting Value: $687.33
Index Ending Value: $1,154.23
Total Shares Purchased: 160.40
Total Dollars Invested: $180,000
Current Market Value: $185,142
Total Profit: $5,142
Total Percent Profit: 2.86%
Annual Percent Profit: 0.19%
So, over the past fifteen years, your investment would have returned less than 0.2% annually. But, looking on the bright side, you have participated in a forced savings program, and you now have a retirement account with $185,000 in it.
What are the lessons going forward?
(1) The S&P 500 Index has been highly volatile over the past fifteen years. We've experienced three asset bubbles and two crashes, and we may well be in the early stages of the third crash.
(2) The S&P 500 Index is currently priced at its long-term average. This means that buying the index now virtually guarantees sub-par long term returns.
(3) A better strategy than DCA might be to watch the index and only purchase shares when the index is currently BELOW its fifteen-year average value of 1160. Clearly this means taking a more active approach to your portfolio purchases, monitoring the index each month before making your purchase decision.
