The US stock market is at record highs, and warnings of a downturn are loud and shrill on every side. Even if you’re convinced you should own more stock, you may find it difficult to buy now. What if you invest your money and the market suddenly drops?
If this fear is holding you back, dollar-cost averaging could help. Dollar-cost averaging involves investing systematically over a period of time to diversify the timing of your entry into the market. It’s tiptoeing into the market rather than plunging right in. How do the results of these two strategies compare?
To find out, we conducted a historical analysis of the US stock market since 1926. This period encompasses more than 1,000 different entry points across a wide range of market environments, from the Great Depression to the bull markets of the 1980s and 1990s and to the global financial crisis in 2008.
Statistically speaking, investing all at once has been the best strategy for maximizing returns (Display 1). The average stock market gain in all rolling 12-month periods since 1926 was 12.2%, while the average result of staying in cash was only 3.6%. Dollar-cost averaging with fixed monthly installments delivered average returns of 8.1% across all the rolling 12-month periods—much better than holding cash but more than 4% worse than investing immediately. That’s because stock markets tend to rise over time, so investing immediately wins on average.
Benefits and Costs
Just because the statistics favor investing immediately doesn’t make it the best strategy for everyone. Dollar-cost averaging has a nonmonetary value, too: It can help you sleep at night. You might think of it as a kind of insurance against the regret you’d feel from a steep market drop right after you invested. Of course, another way to insure against this regret is simply to stay in cash. We examined both strategies to see how much each type of “regret insurance” would cost.
Once again, we analyzed stock market data for each 12-month rolling period from 1926 through 2013. We divided these periods into quintiles, from the strongest to the weakest. The bottom quintile included years as bad as 2008; the top quintile included years as good as 1954, when the S&P 500 rose 53%.
We found that in very poor markets—which occurred 20% of the time—dollar-cost averaging helped preserve capital and resulted in 10% more wealth than investing all at once, but staying in cash was more than twice as protective (Display 2). The other 80% of the time, both dollar-cost averaging and holding cash hurt performance. The question is how much.
In typical markets (the three middle quintiles), you’d have foregone 3.9% with dollar-cost averaging and 9% by staying in cash. The costs were even higher in strong markets, where dollar-cost averaging produced 19.1% less wealth, and staying in cash cost fully 37.8%.
Seen in this light, holding cash is risky relative to being at your target exposure to stocks. Dollar-cost averaging is a way to smooth out timing risk and moderate the potential cost. Whether you decide to dollar-cost average depends on how you weigh the better outcomes in poor markets against the weaker results in typical and strong markets.
If you decide to dollar-cost average, it’s important not to lose your nerve if the market drops after the first few installments. The biggest risk with any investment strategy is the temptation to abandon the strategy and wait in cash. As we’ve seen, going to cash has generally produced the weakest returns. Instead, it helps to remind yourself that dollar-cost averaging just saved you money compared to jumping in all at once, and stick to your systematic investment rule.
In the long run, you’re likely to do best by jumping into the market with both feet. If you’ve been stuck on the sidelines, dollar-cost averaging may help to overcome your market jitters. Either way, the key to achieving your long-term financial objectives is to get to your strategic asset allocation and stay there.
Past performance does not guarantee future returns. The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AllianceBernstein portfolio management teams.
Seth J. Masters is Chief Investment Officer of Bernstein Global Wealth Management, a unit of AllianceBernstein L.P. (NYSE: AB)