A Smarter Way to Dollar-Cost Average — The 2%:75%:50% Rule
Leveraging my value averaging investment strategy can yield higher returns while still minimizing risk
Disclaimer: This is not financial advice. I am not a financial advisor, just a practical guy, writing about a practical world.
What is Dollar-Cost Averaging?
Dollar-cost averaging (DCA) is the process of investing a fixed amount of money over consistent periods of time, such as monthly or quarterly. A common example of dollar-cost averaging is paying a mortgage or car loan. You are paying a fixed amount of money over a recurring period of time, typically monthly. A similar example (and the focus of this post) is with investing, such as in a 401K or mutual fund. The idea is that the longer you invest, the lower the risk of losing money.
Dollar-cost averaging is a way to minimize risk, but research also shows that lump-sum investing is more lucrative over a longer period of time. This is why I came up with a smarter way to dollar-cost average that uses the same principles of DCAing but ensures that your cost basis is as low as possible; ultimately resulting in higher returns. The strategy is optimized to work over a single year, but it also works as a long-term strategy.
Why Dollar-Cost Average?
A dollar-cost averaging strategy is used for a few reasons. The first reason is because of emotions. Humans are emotional-beings and as such, we often make financials decisions with our gut and not our mind. DCAing is a way to take emotions out of the decision-making process. In addition to emotions, DCAing is a way to eliminate the notion that you might actually be able to time the market. Investors usually have regrets when they think they can time the market. But if you are putting a fixed amount in at the beginning of each month, for example, timing the market is never an issue. The last primary reason that investors dollar-cost average is to lower their cost basis, or average purchase price. Because timing the market is not a concern, and a fixed amount is going in each period, the more investments you make the more your cost basis will be reduced as investments fluctuate in price.
Who is Dollar-Cost Averaging For?
Dollar-cost averaging is for people that want to take emotions out of their investment decisions. It is for people that generally have higher stress and anxiety levels. It is also for people who are more focused on growth and have a longer time horizon.
What is the Alternative?
The alternative to DCAing is known as lump-sum investing. This strategy involves investing the entire amount of money at once. One example is paying off your mortgage or car loan. Another example is putting $10,000 in an investment on January 1st instead of spreading out the $10,000 in equal monthly payments throughout the year. The argument for lump-sum investing is maximizing the potential gains, especially if you are sitting on a large amount of cash. In theory, this makes sense. The stock market has typically gone up by an average of 7% a year, over time. Knowing this, if you have a longer-term horizon this should pan out well. The argument against it is maximizing the potential losses. Look back at March of 2020. If you invested $10,000 into a Nasdaq fund right before the March crash, you would have lost almost half the value. Coming back to my comment about emotionally driven decisions, the average investor probably would have cut their losses and sold the investment. On the flip side, if you had invested it all once when the crash bottomed-out, you would have increased your investment exponentially, shortly after. Lastly, lump-sum investing requires more cash at one time that investors don’t always have, and the strategy is usually seen as riskier.
The Problem with Dollar-Cost Averaging
The problem with DCAing is what history tells us. There is a lot of research that shows while dollar-cost averaging makes the most sense for the average investor, it also does not perform as well as lump-sum investing. One such analysis was conducted by Vanguard and highlighted that lump-sum investing outperformed dollar-cost averaging 64% of the time over six months and 92% over 36 months, assuming a traditional 60/40 stock/bond split. Another study was done over a 70-year period and showed that 67% of the time, lump-sum investing outperformed DCAing, in a 12-month period.
There Must be a Smarter Way?
I believe there is a smarter way to execute dollar-cost averaging to realize higher returns, while minimizing risk. I created the 2%:75%:50% rule, which is a type of value averaging, and there are two components; managing losses and managing gains
Let me first say, I believe paying down high interest debt (credit card, student loans, etc.) should always be a priority. However, with how low interest rates are, there should be a good opportunity for deploying the strategy below.
Managing Losses
Let’s say you are currently investing $500/month into an S&P 500 index fund. The first part of the rule, the 2%, is the loss indicator you use to setup your next investment. If the S&P 500 index fund corrects by more than 2% between purchases, you increase the amount of your next purchase. The 75% part of the rule indicates how much higher than your usual recurring investment should be allocated to the next investment. So, in this case, your next investment will be $875, because the S&P 500 corrected by more than 2%, between investments. Continuing with the S&P 500 example, there were four months in 2020 that experienced losses of more than 2%. These would be months that you would increase your contribution by 75%. This strategy ensures you continue the low-risk dollar-cost averaging investment strategy, but it also ensures you lower your cost basis, by capitalizing on larger market dips.
Managing Gains
The next part of the strategy involves minimizing the amount you invest during periods of increased market performance. If the investment is up over 2% when the next recurring investment comes up, then the amount you invest should be 50% less than the usual recurring investment. In this case, if the S&P 500 is up by more than 2%, from one month to the next, then you should only invest $250. Continuing with the S&P 500 example, there were six months that experienced gains of more than 2% in 2020. These months would result in a contribution that is 50% less than the usual amount. This strategy usually results in investing equal to or less than a traditional DCA strategy. Because of that, I propose that you use the remaining $250 to pay down high interest debt, such as credit cards or student loans. Since $500 a month is already factored into your recurring expenses, there is no reason you should just leave it in cash. Paying down debt is an opportunity that presents itself, as a result of this strategy.
The Results
I deployed this strategy for all of 2020 using my brokerage account. My brokerage account has a combination of index funds that encompass the four major indices, Dow Jones, Nasdaq, S&P 500 and Russell 2000. As a baseline, I DCAed an equal amount into each index at the beginning of January, while following the strategy above. Over the course of the year, I invested roughly $12,000, some months at my usual purchase amount and some months below or above the amount, based on my strategy. My total return was roughly 24%. Had I instead invested the $12,000, split equally into each index, on January 1st (lump-sum), I would have ended up with roughly $14,500, or about a 21% gain, at the end of the year. Even more interesting, had I just dollar-cost averaged $1,000 each month, into the S&P 500 index fund, I would have been up 19% on the year, higher than the 16% S&P 500 return the lump-sum investment would have netted me. Conversely, the Nasdaq ended the year up 43% with a lump-sum investment. Had I dollar-cost averaged the Nasdaq, equally, each month, I would have netted 42%. It goes to show you that there is variance between the strategies, but that is also why diversification is so important and trying to time the market is very difficult to do.
Quick Analysis
I started with an analysis of the S&P 500 across all of 2020. I found that my strategy beat both traditional dollar-cost averaging and lump-sum investing, from a cost basis and overall return. I then analyzed the four prior years, which had positive and negative years, and I found that my strategy beat traditional dollar-cost averaging every single year, by an average annualized rate of 9.45% to 8.3%.
Dollar-cost averaging is a great way to remove emotions from investing decisions. Lump-sum investing is a statistically proven way that usually outperforms dollar-cost averaging in the long-term. However, as seen above, a smarter way to dollar-cost average can net you more gains, while minimizing the actual amount you end up investing in the market. It also supports paying off high interest debt with the excess cash. No matter what investment decision you choose, do the research, weigh the pros and cons, create a plan and stick to it.
Questions? Comments? Feedback? Reach out to me at trythepracticalworld@gmail.com or find me on Facebook, LinkedIn, Twitter and Instagram (@thepracticalworld)
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Sources
https://www.moneyunder30.com/dollar-cost-averaging-vs-lump-sum-investing
