Under the lump sum method, the investor purchased 24 shares in January, so the investment value in June was $513 (24 shares times $21.38 per share). The investment decreased 14.5%.
With dollar-cost averaging—as the mutual fund declined below its January share price—each month’s $100 investment bought more than four shares on average. After six months, the investor accumulated 26.20 shares, and the investment was worth $560.16 (26.20 shares times June’s $21.38 share price.) The investment is down only 6.64%.
Does Market Timing Work?
Instead of consistent buying, some investors get drawn into timing the bottom or dips in the market.
Academic research in finance has proved that trying to time the market accurately is nearly impossible. Berkshire Hathaway Chairman and CEO Warren Buffett gave his take on market timing during the company’s 2022 shareholders’ meeting in April.
Attempting to predict a decline, let alone the end of a drop, is very difficult.
Dollar-Cost Averaging Versus Buying the Dip
The strategy of “buying the dip” attempts to pinpoint market downturns. Here, an investor builds up money to invest, but keeps it in cash and invests it only when the price of an investment declines (dips) from a recent high.
If an investor could accurately predict dips, would it not be better to just buy the dip?
A recent analysis looked at returns for a person with a 40-year time horizon who could time market bottoms perfectly. If they started investing in the S&P 500® anytime between 1920–1980, dollar-cost averaging would still outperform buying the dip 70% of the time.² When the investor’s accuracy was reduced, and they invested within two months of the actual bottom, the strategy underperformed 97% of the time.³ It’s worth noting that neither method will save you from losses if the investment declines in value over your investment time horizon. But when looking at strategies for investing, you typically will do so in investments that you think will rise over time.
Why did consistent investing outperform?
The Power of Compounding
While waiting for the dip, the investor is building cash on the sidelines that does not benefit from making investment returns.
Historically, the market can go several months and even years without experiencing a decline large enough to be considered a dip. Missing just a handful of days in the market can drastically reduce an investor’s average returns over time.
Staying in the market and putting your investments to work systematically captures one of the most important aspects of long-term investing—compounding.
Automatic Investing Tames Emotions and Simplifies Decisions
Dollar-cost averaging lends itself practically to the investment process. By taking the investment decision off of the investor’s plate—much like what’s done with contributing to a 401(k)—an investor can easily stick to an investment plan.
Breaking down the purchase of investments into several smaller blocks also greatly reduces the risk of regret from ill-timed purchases. When the market falls, you can be happy to add to your investments at lower prices, and when the market rises, you can be happy that you got in at lower prices.
