Even God couldn’t beat dollar-cost averaging
IF THE LAST chapter didn’t convince you to abandon market timing forever, this one surely will. It’s a bold claim, but one I am prepared to back up with data.
To start, let’s play a game.
Imagine you are dropped somewhere in history between 1920 and 1980 and you have to invest in the U.S. stock market for the next 40 years. You have two investment strategies to choose from:
1. Dollar-cost averaging (DCA): You invest $100 every month for 40 years.
2. Buy the Dip: You save $100 each month and only buy when the market is in a dip. A dip is defined as anytime when the market is not at an all-time high. But, I am going to make this second strategy even better. Not only will you buy the dip, but I am going to make you omniscient (i.e., “God”) about when you buy. You will know exactly when the market is at the absolute bottom between any two all-time highs. This will ensure that when you do buy the dip, it is always at the lowest possible price.
The only other rule in this game is that you cannot move in and out of stocks. Once you make a purchase, you hold those stocks until the end of the time period.
So, which strategy would you choose: DCA or Buy the Dip?
Logically, it seems like Buy the Dip can’t lose. If you know when you are at a bottom, you can always buy at the cheapest price relative to the all-time highs in that period.
However, if you actually run this strategy you will see that Buy the Dip underperforms DCA in more than 70% of the 40-year periods starting from 1920 to 1980. This is true despite the fact that you know exactly when the market will hit a bottom.
Even God couldn’t beat dollar-cost averaging!
Why is this true? Because buying the dip only works when you know that a severe decline is coming and you can time it perfectly.
The problem is that severe market declines don’t happen too often. In U.S. market history severe dips have only taken place in the 1930s, 1970s, and 2000s. That’s rare. This means that Buy the Dip only has a small chance of beating DCA.
And the times where Buy the Dip does beat DCA require impeccable, God-like timing. Missing the bottom by just two months lowers the chance of Buy the Dip outperforming from 30% to 3%.
Instead of taking my word for it, let’s dig into the details to see why this is true.
Understanding How Buy the Dip Works
To start, let’s consider the U.S. stock market from January 1996 to December 2019, a 24-year period, to familiarize ourselves with this strategy.
In the first chart, I have plotted the S&P 500 (with dividends and adjusted for inflation) over this 24-year period. All-time highs are also plotted, as gray dots.
Now, I am going to show the exact same plot as above, but with the addition of a black dot for every dip in the market (defined as the biggest decline between a pair of all-time highs). These dips are the points at which the Buy the Dip strategy would make purchases.
As you can see, the dips (black dots) occur at the lowest point between any two all-time highs (gray dots). The most prominent dip over this time period occurred in March 2009 (the lone black dot before 2010), which was the lowest point after the market high in August 2000.
However, you will also notice that there are many less prominent dips that are nested between all-time highs. These dips cluster during bull markets (in the mid-to-late 1990s, and mid 2010s).
To visualize how the Buy the Dip strategy works, I have plotted the amount the strategy has invested in the market and its cash balance over this time period from 1996 to 2019.
Every time this strategy buys into the market (the black dots), the cash balance (gray shaded area) goes to zero and the invested amount moves upward accordingly. This is most obvious when we look at March 2009 when, after nearly nine years of cash savings, Buy the Dip invests $10,600 into the market.
If we compare the portfolio value of Buy the Dip and DCA, you will see that the Buy the Dip strategy starts outperforming around the March 2009 purchase. This is shown in the next chart. Once again, the black dots represent every time the Buy the Dip strategy makes a purchase.
If you want to understand why this one purchase is so important, let’s consider how much each individual purchase for the DCA strategy grows to by the end of the time period, along with when the Buy the Dip strategy makes purchases. Each bar in the next chart represents how much a $100 purchase grew to by December 2019.
For example, the $100 purchase in January 1996 grew to over $500. The black dots once again represent when the Buy the Dip strategy makes purchases.
This chart illustrates the power of buying the dip as every $100 invested in March 2009 (that single dot towering near 2010) would grow to nearly $450 by December 2019.
There are two additional things to notice about this plot:
1. The earlier payments, on average, grow to more (compounding works!).
2. There are a handful of months (e.g., February 2003, March 2009) where some payments grow to considerably more than others.
If we put these two points together, this means that Buy the Dip will outperform DCA when big dips happen earlier in the time period.
The best example of this is the period 1928–1957, which contains the largest dip in U.S. stock market history (June 1932).
Buy the Dip works incredibly well from 1928–1957 because it buys the biggest dip ever (June 1932) early on. Every $100 you invested at the market bottom in June 1932 would have grown to $4,000 in real terms by 1957! There is no other time period in U.S. market history that even comes close to this.
I know it might sound like I am trying to sell the Buy the Dip strategy, but the 1996–2019 and the 1928–1957 periods just happen to be two periods where there were prolonged, severe bear markets.
If we look over longer time frames, historically, Buy the Dip doesn’t outperform most of the time. The next chart shows the amount of outperformance from Buy the Dip (as compared to DCA) over every 40-year period over time. Outperformance is defined as the final Buy the Dip portfolio value divided by the final DCA portfolio value.
When Buy the Dip ends with more money than DCA it is above the 0% line, and when it ends with less money than DCA it is below the 0% line. To be precise, over 70% of the time, Buy the Dip underperforms DCA (i.e., it is below the 0% line).
What you will notice is that Buy the Dip does well starting in the 1920s (due to the severe 1930s bear market), with an ending value up to 20% higher than DCA. However, it stops doing as well after the 1930s bear market and does continually worse. Its worst year of performance (relative to DCA) occurs immediately after the 1974 bear market (starting to invest in 1975).
This 1975–2014 period is particularly bad for Buy the Dip because it misses the bottom that occurred in 1974. Starting in 1975, the next all-time high in the market doesn’t occur until 1985, meaning there is no dip to buy until after 1985.
Due to this unfortunate timing for Buy the Dip, DCA is easily able to outperform. The following chart shows Buy the Dip vs. DCA for the 40 years starting in 1975. As usual, the black dots show Buy the Dip purchases.
As you can see, DCA grows an early lead over Buy the Dip and never gives it up. Despite the handful of big dips that the Buy the Dip strategy purchases in this time period, because they happen later in the time period, there is less time for them to compound.
You can see this more clearly if we look at the purchase growth plot for this period in the next chart.
Unlike the 1928–1957 or 1996–2019 simulations, Buy the Dip does not get to buy large dips early in the period during the 1975–2014 simulation. It does get to buy the March 2009 dip, but this happens so late in the simulation that it doesn’t provide enough benefit to outperform DCA.
This illustrates that even with perfect information, Buy the Dip typically underperforms DCA. Therefore, if you build up cash in hopes of buying at the next bottom, you will likely be worse off than if you had bought as soon as you could.
Why?
Because while you wait for your beloved dip, you may find that it never comes. As a result, you end up missing out on months (or more) of compound growth as the market keeps rising and leaves you behind.
What makes the Buy the Dip strategy even more problematic is that up until now we have assumed that you would know exactly when you were at the market bottom. But, in reality, you will never know this with certainty. You will never have perfect market timing foresight.
I ran a variation of Buy the Dip where the strategy misses the bottom by two months, and guess what? Missing the bottom by just two months leads to underperforming DCA 97% of the time! Even someone who is decent at calling market bottoms and can predict them to within two months of the absolute bottom would still lose in the long run.
Putting It All Together
The main purpose of this chapter is to reiterate that saving up cash to buy the dip is futile. You would be far better off if you Just Keep Buying. And, as we saw in the previous chapter, it’s generally better to invest sooner rather than later. Taken together, the conclusion is undeniable:
You should invest as soon and as often as you can.
This is the core ethos of Just Keep Buying and one that transcends both time and space.
For example, if you had picked a random month since 1926 to start buying a broad basket of U.S. stocks and kept buying them for the rest of the following decade, there is a 98% chance that you would have beaten sitting in cash and an 83% chance that you would have beaten 5-Year Treasury notes as well. More importantly, you would have typically earned about 10.5% on your money while doing so.87
If you were to run a similar analysis for a group of global stocks since 1970, you would have beaten cash in 85% of 10-year periods and earned about 8% on your money.88
In both cases the method for building wealth is the same—Just Keep Buying.
After all, if God can’t beat dollar-cost averaging, what chance do you have?
God Still Has the Last Laugh
One of the most important things I learned while crunching all the numbers for this chapter is how dependent our investment lives are on timing luck (formally known as sequence of return risk, which will be covered in the next chapter).
For example, the best 40-year period I analyzed in this chapter was from 1922–1961, where your $48,000 (40 years × 12 months × $100) in total DCA purchases grew to over $500,000 (after adjusting for inflation).
Compare this to the worst period 1942–1981, where your $48,000 in total purchases only grew to $153,000. That is a difference of 226%, which is much larger than any divergences we saw between the DCA and Buy the Dip timing strategies!
Unfortunately, this illustrates that your strategy is less important than what the market does. God still has the last laugh.
With that being said, the role of luck in investing is where we turn in our next chapter.
87 This is the median outcome for investing every month for a decade into U.S. stocks from 1926–2020.
88 For more detail see: ofdollarsanddata.com/in-defense-of-global-stocks.