If you want to retire wealthy but you don’t have a lot of money there is a simple strategy you can use called Dollar Cost Averaging.
The idea is to save some of your income and put it into the stock market at regular intervals (usually monthly).
Dollar cost averaging typically involves regular investing in low cost ETFs like SPY because they are cheap and provide diversification.
But can you improve on the classic DCA method by incorporating individual stocks instead?
In this article, I present a strategy that invests $1000 into the five strongest stocks in the S&P 500 every month, where strength is measured by the previous 12-month return.
As you will see, the return from this strategy is around 6.5% per annum according to historical backtests over a period of 18 years. This is superior to buy and hold and DCA with an ETF.
1. Dollar Cost Averaging On SPY
Before we look at our new strategy, let’s first see the results of dollar cost averaging with the SPY ETF so that we can later compare our findings.
The following results and equity curve reveal what would have occurred if you had invested $1000 into SPY every month between 1/2000 to 1/2018:
As you can see, you would have made an annualised return of 5.18% with SPY. This compares to a lump sum buy and hold return of 5.67%.
The DCA result is slightly worse than buy and hold. However, we would have ended up with a portfolio worth $533,762.51.
That’s over half a million dollars in less than twenty years so it’s not all bad.
2. Buying The Five Strongest Stocks Every Month
Now we have seen the results from dollar cost averaging with SPY we can try something new and compare our findings.
Below you will see what would have happened if you had invested $1000 into the five strongest stocks ($200 each) in the S&P 500 index every month between the same time period.
To be clear, strength is measured by the previous 12-month performance so each month we invest $200 into the five stocks that showed the best performance in the last year.
Note that if we already have a position in that stock (meaning it was already a past winner) we will buy it again and increase our position in it.
For example, our simulation buys Apple no less than twenty times between 2003 and 2008.
We also ignore any stock under $2 and any stock with a turnover less than $500k.
Importantly, we never sell. We simply keep acquiring stocks throughout the simulation.
As you can see, investing $1000 into the five strongest stocks from the S&P 500 every month has returned 6.5% annually and the portfolio has grown to $668,309.54.
Knock off $10 commission for each trade and our portfolio would be roughly $657,509.
This result is better than DCA on SPY and better than buy and hold as well.
3. Buying The Five Weakest Stocks Every Month
At this point you are probably thinking “this sounds good but what about buying the weakest stocks each month? After all, aren’t we always told to buy low and sell high?”
The following results, therefore, show the same strategy but this time we buy the five weakest stocks:
(Note, since our database includes delisted members we can be fairly confident there is no survivorship-bias in these results).
You can see that we have recorded an annualised return of 4.75% with this method. So buying the weakest stocks hasn’t worked as well as buying the strongest stocks.
4. What About Russell 3000 Stocks?
Now you might be thinking “what if we widen our stock universe to include Russell stocks and not just S&P 500 stocks?”
OK, let’s try the same strategy as #2 but this time let’s spread our $1000 into the five strongest stocks in the entire Russell 3000:
You can see again that the result is not quite as good. We got an annualised return of only 4.32% and a final portfolio value of $460,718.
It seems that buying the strongest stocks in the S&P 500 is the sweet spot.
I have a written a lot about dollar cost averaging on this blog because it is simple and it works.
But I know what you’re thinking. 6% annual return is not much. Not when compared with cryptocurrencies, Buffett or the 32% return we got in 2013.
But think of it another way. With this approach we have built a $600,000 portfolio in less than 20 years and we have done it during a period that saw two vicious bear markets.
It’s clearly obvious that the secret to building wealth is not just in picking the best stocks but having the discipline to save more than you earn putting it to work.
If you want to invest but don’t have a large pot of money sitting around, simply start saving and start investing and keep at it even when markets are up or down.
The strategy I have shown today is unique and works well in our historical tests. You could say that it’s a cross between buy and hold investing and momentum because we buy the strongest stocks but we never sell.
If you want to try this strategy at home, you can use the Amibroker code provided below.
Make sure to set your initial capital to the total capital that will be invested in order to see an accurate simulation.
For example, if you want to invest $1000 each month for 18 years you should set your starting capital at $1000 x 12 x 18 = $216,000:
Simulations and charts in this article produced with Amibroker using data from Norgate Data. This data includes historical members and is adjusted for special actions and dividends.No commissions were used but these would have negligible effect on overall findings.