Reverse Dollar Cost Averaging During Long Bull Markets [Study] by Ben Reynolds, Sure Dividend
A Sure Dividend reader recently asked me a compelling question (paraphrased below):
“What would happen if you used a ‘reverse dollar cost averaging strategy’ as bull markets ran long; what would happen if you sold small portions of your portfolio during long bull markets, and used the proceeds to dollar cost average in during the next bear market?”
As most readers of my work know, I believe in long-term investing; buying great businesses and holding them for the long run. This does not involve trying to time the market.
With that said, the question above is intriguing. At its basic level, the approach above is timing the market, but, it isn’t ‘all in’ and ‘all out’. It takes a very conservative approach to ‘timing’ the market.
I designed a test to see if ‘reverse dollar cost averaging’ is a compelling strategy.
Building The Test
You wouldn’t sell stocks to prepare for a bear market if the market was already undervalued. Therefore, no ‘reverse dollar cost averaging’ should be done when the market is at or below its historical price-to-earnings ratio.
I prefer to use the PE10 (also called the Shiller PE) ratio to measure the overall value of the market.
The PE10 ratio takes into account 10 years of earnings; it ‘smooths’ earnings over a longer time period to better account for 1 year aberrations.
The historical average PE10 ratio for the S&P 500 is 16.6. The market is currently trading at a PE10 ratio of 26.2. The market is overvalued right now, and has been for some time.
Rule 1 of test: Only use reverse dollar cost averaging when market is trading above its historical PE10 average.
Secondly, one shouldn’t reverse dollar cost average when the market has already begun to plummet. Therefore, reverse dollar cost averaging should be done only when the market is trending upward.
Rule 2 of test: Only use reverse dollar cost averaging when market is above its 200 day simple moving average
When the reverse happens, do the opposite. Purchase using funds tucked away from reverse dollar cost average sells.
Long-Term PE10 View & ‘Never’ Buying
The image below shows the PE10 of the S&P 500 and the historical average of the PE10.
Source: Data from Multpl.com
What immediately jumps out is that the market has been above its historical average since around 1990. The only exception is a very brief period from November 2008 through May 2009.
If you were looking to only buy when the market was undervalued and you started investing in 1990, you’d wait a very long time before even thinking about entering the market – missing out on some of the biggest bull runs in history.
Performance Comparison: Round 1
Performance was compared at different monthly dollar cost averaging rates. Liquidating 1% of your portfolio a month when the market was above its 200 day simple moving average and above its historical PE10 average is ‘1%’ in the image below.
Similarly, this test adds 1% of your liquidated cash pile back into the market when the market is below its 200 day simple moving average and below its historical PE10 ratio.
The following dollar cost averaging rates were compared:
- None, called buy and hold
- 0.5% a month
- 1.0% a month
- 2.0% a month
- 3.0% a month
Total return data was used from the SPDR S&P 500 ETF (SPY). Data starts on the first day SPY was publicly traded – January 29th, 1993.
As you can see, buy and hold was the best at compounding long-term wealth over the last 20+ years.
Dollar cost averaging was computed daily. This would cause significant transaction costs (which are not included) if done in the real word. On the other hand, money invested in ‘cash’ would have earned an interest rate, which is not included in the study either.
Length & Duration of Bull Markets
The average bull market lasts 5 years and 7 months. Bull markets are defined as a rise of at least 50% from the bottom of a bear market, over a period of at least 6 months. Bear markets are defined as a price drop of 20% or more over a period of at least 3 months.
The images below (from 2013) shows the length and duration of bull markets:
Source: GestaltU
Source: GestaltU
What would happen if you ‘reverse dollar cost averaged’ only after a bull market has run longer than its historical average of 5 years, 7 months, and began the opposite operation (slowly buying) when the market entered into a recession (stopping buying only when the bear market ended)?
The image below shows when this strategy would be buying (in green), selling (in red), and holding (in gray).
I tested this idea using different reverse dollar cost averaging rates (shown below) and total return data from the SPDR S&P 500 ETF (SPY). Data starts on the first day SPY was publicly traded – January 29th, 1993.
- None, called buy and hold
- 0.5% a month
- 1.0% a month
- 2.0% a month
- 3.0% a month
Performance Comparison: Round 2
Did using average bull market length make for an implementable market timing strategy? The results are below:
As you can see, buy and hold was still the most effective strategy at compounding long-term wealth. With that said, using bull/bear market length rather than market valuation level has been a better market timing strategy over the last ~20 years.
Final Thoughts
Recessions are difficult to deal with. They can cause panic selling. Unfortunately no one knows when one will occur. Even experts who ‘get it right’ tend to have predicted 12 of the last 3 recessions – they call for a recession and one doesn’t occur.
That’s the problem with taking money out of the market in preparation for a recession. You may time it just right, but that’s unlikely.
If you don’t time it just right, you could potentially miss out on years or decades of favorable market growth.
On balance, buying and holding takes advantage of the favorable long-term wealth creation effects that free markets create.
Timing the market is trying to ‘get ahead’ of normal business growth. It’s like gambling; it might work out for you, but on average, the house always wins. Investing in great businesses and holding them is the exact opposite.
Buying and holding is difficult. It’s hard to hold onto your investments when the market is collapsing. It is also the best strategy (especially when considering frictional costs) of compounding wealth over long periods of time.
Prepare for recessions by investing in high quality businesses that perform well during recessions (and also perform well during times of prosperity), not by attempting to time when a recession occurs.
