Trading Basics: Evolution of a Trader

DOLLAR-COST-AVERAGING: GOOD OR BAD?

Grandma Moses dies and leaves you $12,000. Do you blow it all at once on stocks or spread the pain over a year? By spreading it out over a year, you buy more shares if the stock's price drops and buy fewer shares if the price rises. That method is called dollar-cost-averaging (DCA) and it has been around for a long time. But is it the smart play?

I programmed my computer to use the S&P 500 index starting from January 3, 1950, to May 13, 2010. At the first trading day of each month (February 1, 1950, would be the first buy date), the test bought at the closing price for that day and held it for a year (selling on the last trading day of the 12-month span—January 31, 1951), investing $12,000. Another test spent only $1,000 in February, but added another $1,000 each month until it spent the last dollar at the start of January. At the end of January, all shares were cashed out at the closing price.

I then repeated the test using the next yearly span, March 1950 to February 1951, in a series of overlapping, 12-month periods, until I ran out of data. I found that if you total the values from each yearly interval, the invest it all, now would have made $705,147. Investing a grand a month would have made $371,445. The invest it all, now group would have beat dollar cost averaging in 500 competitions (70 percent of the time), and DCA would have won 212 races.

In other words, invest the money as a lump sum. Do not invest it using dollar cost averaging ...