Market Timing versus Dollar-Cost Averaging: Evidence based on Two Decades of Standard & Poor’s 500 Index Values
Kim Johnson
Department of Accounting
412I Wimberly Hall
University of Wisconsin-La Crosse
La Crosse, WI 54601
(608) 785-6836
and
Tom Krueger
Department of Finance
406B Wimberly Hall
University of Wisconsin-La Crosse
La Crosse, WI 54601
(608) 785-6652
Submitted for Publication in the Journal of the Academy of Finance Presentation at the
2004 Academy of Finance Annual Meeting Market Timing versus Dollar-Cost Averaging: Evidence based on Two Decades of Standard & Poor’s 500 Index Values
“Dollar cost averaging is a technique which enables investors to reduce the short-term
impacts of market highs and lows.” www.vanguard.com
“As a convenience, investors can authorize systematic investments to take advantage of dollar-cost averaging strategies.” www.tdwaterhouse.com
“The Use of Dollar Cost Averaging is the Second Step in Successful Savings” www.merrillynch.com
“ By using the dollar cost averaging investment technique even if you are investing for the long run (ten years or more) and the market goes down, in the end you will be a winner.”
www.suzeorman.com
Introduction
As evidenced by the above quotes, dollar-cost averaging (DCA) is a popular investment method wherein an investor with a sum of money to invest does not invest the entire sum immediately. Instead, a fixed proportion of the available dollars is invested at equal, scheduled intervals through time. The intervals might be a week, month, quarter, or year. By following DCA, an investor ends up purchasing more shares when prices fall and fewer shares when prices rise. In this way, it is assumed that investors will not invest their entire sum at a market high and thus, subsequently, regret their investment decision.
Suggestions regarding investment transaction timing are also frequently distributed by financial planners. Examples at the national level include Simon’s (1994, p. 38) Money article on DCA. At the local level is an article published in the La Crosse Magazine titled “Riding the Roller Coaster”. Contained within the article is a chart depicting the hazards of market timing that demonstrates the disadvantage of being out of the market on the best 10 days, 20 days, 30 days, 40 days, and 50 days (North Central Trust Company, Fall 2002). The article, however, does not consider the impact of being out of the market on the worst 10 days, 20 days, 30 days, 40 days, and 50 days. It also implicitly conflicts with the concept of DCA, by assuming full investment at the beginning of the period less the identified days.
This study first presents a literature review covering articles about DCA and alternative investment strategies. It then presents results from our investigation of the impact of not being invested in the S&P 500 during the worst trading days of the period including1982 through 2001. It will also consider the value of using DCA over the same period, using monthly and quarterly investment periods. Finally, our study will determine whether the use of DCA in other stock market indexes and bond indexes would have produced higher returns during the period under question.
1 Review of the Literature
Reference to DCA goes back many decades. In 1925, Mongtgomery (1925, p. 1416) urges financial managers to use a “diversification of maturity” strategy, because “the constant reinvestment of funds places one in a position always to take advantage of such price opportunities as arise.” In 1967, Cohen, Zinbarg, and Zeikel (1967, p. 51) observe “Dollar-cost averaging allows one to buy a greater number of shares of any stock when the price is down. Dollar- cost averaging is most helpful in buying growth stocks.” Constantinides (1979) acknowledges DCA’s ability to reduce the risk of investing but still finds DCA to be a theoretically sub-optimal investment
