In the previous post of this series, I looked at how the return per unit of risk of a Dollar-Cost-Averaging strategy to investing a large sum of money has historically been lower than a Lump-Sum strategy. In this post, I would like to look at another risk metric, maximum drawdown, to see if DCA adds value in this regard.
If you’re new to the term, drawdown, find the definition here. It is basically the difference between the peak value recorded of an investment and a subsequent trough value recorded during an investment horizon.
Intuitively, it makes sense that spreading out investment over a period of time would reduce drawdown since the uninvested portion of the initial cash would not incur any loss. Let’s see how the two different strategies performed in SPY for the past 25 years.
First, take a look at the price chart of SPY in the year 2010.
If I had $10K to invest on Jan 1, 2010. The following chart shows the change in the value of the two accounts.
The red portion of the line shows the maximum drawdown period. In this particular example, the maximum drawdown realized of the Lump Sum strategy is $1694.39 whereas that of the DCA strategy is $662.24. As expected, DCA significantly reduced the maximum drawdown of the investment.
Below, I plotted the histogram of $-maximum drawdowns in the 25-year history.
As expected, we can see that DCA can reduce the magnitude of drawdown, mostly due to the uninvested cash sitting idle.
Intuitively, DCA seems like a less risky investment strategy than Lump Sum (LS). One might have thought that Sharpe ratio of DCA would be higher than that of LS. We showed using the SPY chart that it was not the case. DCA did, however, reduced the drawdown due to the fact that there were uninvested cash impossible to incur a loss.
For investing in SPY, my conclusion would be that Lump Sum has been a much better investment than DCA. It is simpler to implement (1 transaction rather than multiple) and it has higher Sharpe Ratio. The good thing about DCA is that it can reduce drawdown; however if your main goal is to reduce drawdown you can just reduce the aggregate investment amount. Given fixed total investment size, it would be wise to just stick to Lump Sum.
The question remains. Is this true in general? Or does it have to do with the price trajectory of SPY in particular? I’ll answer this is the next post.