The Pitfalls of Dollar Cost Averaging

I recently saw a post from a “friend” of mine who shared that the downturn in the stock market had caused his portfolio to lose more than $120k.

And he wasn’t upset about it.

WHAT???

He touted the age old advice of “dollar cost averaging” saying that he would be “buying at a discount” so it was all good.

A little background on this “friend” of mine: He has been investing for the past 6 or 7 years and initially he was very open that he didn’t know anything about the market and suggested people  “follow along and learn with me”.

He went on to start a podcast about investing and has had all kinds of “experts” on to discuss different investing options and strategies in the market.

He participated in the longest bull market in the history of the stock market from 2008 until COVID-19 struck in 2020; 12 years of inexplicable increasing market value. (For comparison, most bull markets last no more than 3 years). 

So maybe I need to cut him a little slack for not knowing how to handle a real downturn in the market…

But it seems to me that this guy — who arguably has a LOT more knowledge than the average Joe — is still stuck on dollar cost averaging and is losing out on so much money by sticking with this single strategy.

I get it. ALL of the “experts” preach the benefits of dollar cost averaging. You are able to “buy” more when the price is lower, so that when the market turns around, then you are in a “good position”.

Why Everyone Teaches Dollar Cost Averaging

It’s simple — so easy that you could teach a chimpanzee:

Just keep your money in the market and just keep putting your money in the market every month.

You don’t need to know how to read a chart, you don’t need to understand any of the variables in the market. Just keep it steady.

And when investing in a bull market, this works really well. Any minor “dips” in the market don’t impact your bottom line enough for it to dramatically affect your balance. And because you are continually adding to your account each month, the negative impact of any “dips” aren’t as obvious.

But Dollar Cost Averaging Costs You A LOT of Money

Especially during a bear market.

Let’s take a look at some numbers.

Since no one can predict what the market will do in the future, let’s go back to the previous two bear markets (in 2000 & 2008), and move forward from there. We’ll assume that you are putting in money every month (as that’s the only way dollar cost averaging works).

For this example, I’ll use the S&P 500 ETF as the indicator and look at starting to invest in 1998 (two years prior to the bear market) when the average cost per share was around $100 (the yellow line in the chart below). [Note that each bar in the chart represents 1 month.]

For the next 2 years, things look really nice as the market increases up to ~$150 per share (the teal line in the chart above). You are still positive and averaging all of your monthly stock purchases puts you around $125 per share. 

For these two years, you averaged a 12.5% annual return. Not bad at all.

However, in the fall of 2000 the market changes from bull to bear (see the blue downward trend line in the chart above) and by early 2003, the price is down to ~$80. Your average is now ~$120 over a 5 year span and you are looking at an averaged ~4% annual return.

(That bull market looked so much better!)

It is not until mid 2003 that the price rises to your initial purchase price of $100 (yellow line in the chart above). Over the next 4 years the bull market continues and the price rises to just over $150. Your average price is still right around $120 and for these 9 years, you realized an ~2.8% annual return.

(I thought I was supposed to make more when the market went down because I could now buy more shares??)

By late 2007, the market has again changed to a bear market (see the second blue downward trend line in the chart above)  and the next 2 years sees a sharp decline in price all the way down to $70. Your average price is now roughly ~$115. So for the past 11 years, you are looking at a 15% increase over 11 years, or ~1.5% annually.

(At this rate of return, I would have been better to invest my money in a high-yielding savings account and saved myself the pain of watching my balance teeter back and forth!)

Over the course of the next 11 years (see the chart above), the stock market experienced the longest bull market in history! Your average price over these 11 years is ~$200 and you end up making just over 60% on your money in this record bull market. This equates to a 5.6% annual return over these 11 years

Congratulations — you profited from an amazing run up of the market!

If you take a look at your overall dollar cost averaging for the entire 22 years, then you averaged a 3.6% annual return. Not bad. You beat the average rate of inflation of 2.1% over this time period by 1.5%.

However, both of the above calculations are based upon you getting out at the peak of the market (in Jan 2020). Let’s just assume that you missed the peak. We are talking about dollar cost averaging here, not timing the market, so the likelihood of your timing being perfect is about nil.

So let’s just take a look at the numbers if you didn’t get out until ~$225 ($100 below the high-point). All of a sudden, your 3.6% annual return is now down to under 2%.

Less than 2% return each year on your money over the past 22 years. Ouch!

Surely there is a better way…

Definitely. Check it out here…

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