Most people recommend dollar-cost averaging as a measured way of starting to invest. But what is it exactly, and what kind of investor is it suited for?
In this article, we'll weigh the pros and benefits of dollar-cost averaging versus lump-sum investing, so you can choose the most suitable investment strategy for you.
Dollar-cost averaging (DCA) vs lump-sum investing (LSI)
Dollar-cost averaging (DCA) refers to periodic, recurring investments of a fixed amount of money into a specific asset. You can either have a total investment amount in mind or have an ongoing fixed investment as a savings plan.
For example, you can decide to invest a fixed sum of HK$10,000 on the 1st of every month regardless of the state of and your opinions on the stock market.
The power of a dollar-cost averaging is that it helps to remove any emotional connection you have and also minimises timing risk. As such, you're less likely to make impulsive, speculative decisions based on personal opinions or market conditions, or put off investing and stay in cash without putting your money into work.
For beginner investors, dollar-cost averaging also allow you start smaller from earlier on in your career, based on what you can afford. This will let you gain more investment experience as your income grows. You also take less risk than lump sum investments.
Lump-sum investing is often brought up as a counterpoint to dollar-cost averaging. Lump-sum investing refers to investing all the money you have in mind (sometimes called the total investable amount) at one go.
How do their returns differ?
Based on research by Vanguard, simulating historical returns of the MSCI World Index returns from 1975-2022, lump-sum investing generally outperfomed dollar-cost averaging 68% of the time across global markets measured after one year.
However, when compared to staying in cash, dollar-cost averaging strategy outperforms not investing 69% of the time, almost identical to lump-sum investing's probabilty of beating cash.
Therefore, for investors who might have difficulty reigning in the emotional roller coaster with investing — afraid of price drops or chasing valuation highs, DCA might be a great strategy to get you on a disciplined journey to stay invested.
Historical data shows that just missing a handful of the best trading days of the market, can cause drastic decrease in your overall investment returns. Just by missing 25 best best single days from 1990-2021 would have almost cut your annualized returns by half from 10.76% to 5.55%.
Investing through dollar-cost averaging appeals in a downturn
Also, potential higher returns from lump-sum investing come at a price. Just as you could invest before a period of market growth, you could also mistime the market and invest right before the market crashes. This means that you'll have to wait longer to see positive returns, which might be lower than if you had averaged your investments on a dollar-cost basis.
By its nature, dollar-cost averaging accounts for the state of the markets. Within a fixed amount you have committed to invest every month, you buy more when prices are low and buy less when prices are high.
Simply put, when markets are falling, the DCA strategy allows you to lower your average cost per share over time. Taking a DCA approach lets you ride out market lows to enjoy the market recovery later.
The chart below by Morningstar reviews lump sum investing versus dollar-cost averaging during one of the worst decades on record for US stocks (the 2000s). This unique decade shows us the value of dollar-cost averaging in reducing volatility, and improving outcomes (when the market is doing poorly).
To learn more about why it's a good idea to invest regularly during a downturn, click here.
Stay invested in diversified, low-cost portfolios
A final point to note is that we should not end up averaging down on a bad investment through dollar-cost averaging. Averaging down on an investment with poor or unknown prospects will only increase your exposure to bad investments.
So besides looking at your dollar-cost averaging approach, ensure also that your investments include meaningful diversification, and mind the all-in investing cost.
With Endowus, you can do both lump-sum investing and dollar-cost averaging with your money — in globally diversified, intelligent, and low-cost funds and portfolios seamlessly such as our Endowus Flagship Portfolio. You can set up recurring investments and manage them anytime, anywhere, on our platform.
Click here to get started on your wealth journey with Endowus Hong Kong today.
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