Editor’s note: This article was first published in February 2014. Its figures are from then, including the S&P 500 up 177% since March 2009 and the Nikkei 225 at about 15,000 points. The statement that the Nikkei had never recovered its 1989 level no longer holds, as it passed that record in February 2024.
With or without investment experience, if we are very clear that our investment horizon is long term, the odds multiply in our favour. And if, on top of that, we properly set up a strategy that has already been tested, so much the better. Sometimes doubts arise as to whether the market will keep rising or whether, on the contrary, a severe correction, or even a change of cycle, is about to begin.
There is an investment strategy called DCA (dollar-cost averaging), or what I have always called “eternal averaging”. This strategy is very effective when we invest directly in an index; and if we add a few touches of our own and adapt it to individual shares, we would basically have a perfect strategy whose only requirement is that we are very clear that we will need to keep averaging for 5 or 10 years.
Any investor who applied this strategy to the S&P 500, starting to invest at the 2007 peak (1,557 points) and riding out the fall that took the index to its 2009 low (680 points), should be rolling in money right now, because indices tend to recover: in the case of the S&P 500, it has risen 177% from March 2009 to today. We explain the strategy, its exceptions and the touches we are going to add to this simple, profitable investment strategy.
What is the DCA strategy?
Once you are clear that the long term doesn’t worry you, but you are concerned about buying at the top of the market, the DCA strategy basically consists of avoiding going “all in” with your money (investing all your capital at once). The idea is to invest a fixed amount of money in an asset at regular intervals. If the asset’s price falls, we buy; if it falls a lot more, we buy more (or a lot more). That way, even if we started investing at the asset’s highest price, we make sure we will also be buying at its lowest.
We start from the premise that prices always return to where they were*, and so there will come a time when we are buying as many as five times more shares for the same money as with our initial purchase.
The advantage is very clear: if we had invested all our capital up front, we would have watched it lose value for a long time, and during that fall we would have been bearing the opportunity cost.
Andy Kiersz, a mathematician who works for Business Insider, ran this hypothetical experiment, applying the strategy to the S&P 500 at the most critical moment for the market.
If an investor had started this DCA strategy in October 2007 (the S&P’s all-time high up to then), the worst possible time to buy shares, putting 50 euros into an index fund every month, they would have earned a 48% return. That’s an average annual return of 7.6%, despite having bought all the way through the market’s tumble.
If that investor, gripped by panic, had decided to stay out of the market and put 50 euros under the mattress every month, they would now have 3,800 euros. With the DCA strategy started at the worst moment, the investor would have 5,631 euros. In other words, they would have made 1,831 euros (a 48% return).
Of course, Andy did this purely as an example; investing 50 euros at a time isn’t advisable, since the fees alone would eat up the capital.
A few touches to the DCA strategy
In the case of the S&P 500 it worked, as the index is already above its previous all-time highs. We always start from the premise that indices tend to rise in the long run, but if we look at the Nikkei 225 and had applied this strategy in 1989, we would have failed: the Nikkei was trading at 39,000 points then and is currently at 15,000. So there are exceptions too, but we can get around them if we forget about indices. Mind you, the numbers on the Nikkei would need working out, since we would also have bought it at its lowest point (7,000 points).
Let’s turn to individual shares. Some time ago we explained how to build an investment strategy based solely on dividends, where a 10% annual return was achievable.
If we apply the DCA strategy to a solid stock with good dividends, our return could run into three digits.
Without going any further, if we had invested the same amount of money in Banco Santander every month since its peak, even though Santander’s price is still a long way from surpassing its pre-crisis high, our return right now would be very positive, given that the purchases averaged in near its all-time lows plus the dividends paid over these years would already have given us our well-deserved reward.
Now, we have framed this strategy as if the investor were a “blockhead” who can’t think beyond DCA. If we avoid getting in at the worst moment (peak prices), and when prices fall astronomically we double or even triple our usual amount instead of investing the same sum, we tilt the odds and the returns much further in our favour.
This strategy is suitable for young people who want to start their own retirement plan, and even for people aged 30 to 40 with considerable capital and a stable income. Let’s say it’s a way to make money on the stock market without knowing anything about the stock market, while always avoiding the most common investing mistakes.
However, be careful when choosing the company you apply this strategy to: if the company doesn’t get through the crisis it is going through and that is eroding its value, we put 100% of our capital at risk.
Further reading
- 10 mistakes to avoid when investing
- What Warren Buffett never did, and what he always was
- Peter Lynch’s “three Cs” of investing
- 5 steps to getting rich, by Charlie Munger, Buffett’s right-hand man
Featured image: Wpcpey, CC BY 4.0, via Wikimedia Commons.
