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 benefits of dollar-cost averaging before considering how lump-sum investing might be better, so you can choose the most suitable investment strategy for you.
What is dollar-cost averaging and how does it work?
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 investment, as a savings plan.
For example, imagine that you have decided to invest a fixed sum of $1,000 on the 1st of every month. This means that regardless of the state of and your opinions on the stock market, the country you happen to be in, whether your salary comes in early, or even if you’d like to invest more that month, you stay committed to that $1,000 on the 1st of every month.
What are the benefits of dollar-cost averaging?
1. Helps those unfamiliar with investing to get started
Dollar-cost averaging allows those who are just starting to invest to get their feet wet. It will help you to gradually gain market exposure and investing experience.
It doesn’t have to be a sizeable sum that you invest. In the long run, the cumulative value of the investment will grow, boosted by the power of compounding. Dollar-cost averaging can come across as less daunting for many reasons. As a beginner, dollar-cost averaging lets you start smaller from earlier on in your career, based on what you can afford. This will let you glean more investment experience as your income grows. You also take less risk than lump sum investments.
2. Reduces market risk and prevents you from timing the market
The routine of dollar-cost averaging forces you to adopt a passive investment strategy. This removes 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. This makes dollar-cost averaging a good strategy for those with a low risk tolerance.
The research chart below by Morningstar reviews lump sum investing (LSI) versus DCA during one of the worst decades on record for US stocks (the 2000s). This unique decade shows us the value of DCA in reducing volatility, and improving outcomes (when the market is doing poorly).
3. Lowers average cost per share over time (IF the market trends lower)
By nature, dollar-cost averaging accounts for the state of the markets. Because you invest a fixed amount each month, you account for market fluctuations. Within the $1,000 you have committed to invest every month, a lower asset price means you’ve purchased more of the asset and vice versa.
In short, you buy more when prices are low, and buy less when prices are high. Over the long-term, as you accumulate more of the asset at lower prices (assuming markets trend lower), this means you lower your average cost paid per share over time.
Dollar-cost averaging lets you ride out market lows so you can avoid regret aversion and enjoy the market recovery later.
Warning against DCA: Markets grow over time - around 60% of monthly returns and 65% of annual returns are positive. This means that you have a higher mathematical likelihood of being better off by LSI versus DCA (more details below).
What about lump-sum investing (LSI)?
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) in one go.
Comparing the returns from dollar-cost averaging versus lump-sum investing
Mathematically speaking, investing a lump sum gives you higher returns than dollar-cost averaging. As the market grows in the long-run, so does the value of the assets you invest in. Thus, investing a lump sum over that duration will be more financially rewarding. This results from a higher principal (initial invested value), leading to a greater absolute dollar value of returns.
The following diagram is based on research from Vanguard. It displays the performance of a 60% stock/40% bond portfolio over a 12-month rolling period, with a monthly DCA interval.
Note that the previous market crashes like in 1929, 1987, 2001, and 2008 are factored into this research.
If the number is positive, it means that DCA outperformed LSI, and as you can see, DCA only performed better in the worst performing 3 deciles (30th percentile) of all periods.
This trend exists regardless of your asset allocation, be it 100% equity or 100% bonds.
However, these potential higher returns 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 dollar-cost averaged.
What should you do?
Ideally, you should avoid this problem in the first place. Invest all the money that you are willing to commit as and when you have the money to invest. As most of us are employees and pay our bills on a monthly basis, invest all your monthly savings into the market at a level of volatility that you can tolerate, and towards your goals. This way, you don’t need to time the market or worry about losing out because you are not invested enough.
It’s all about combining the best of both worlds. Ditch a conventional dollar-cost averaging strategy. Instead, invest a larger sum of money regularly so that you aren’t sitting on a pile of cash.
Don’t end up averaging down on a bad investment when you DCA.
While it's hard to time the markets, we have to ensure that our investments have a high probability of making a decent return. Yes, that means that dollar-cost averaging into cryptocurrencies is still very risky. Averaging down on an investment with poor or unknown prospects will only increase your exposure to bad investments.
Be invested intelligently, with meaningful diversification, cost management, and passively towards your goals and not try to time the market.
Regular Savings Plans (RSP) are very popular in Singapore. When you gain investment experience, you'll probably pull away from dollar-cost averaging as it has a lower expected return, but as a way to get comfortable with the markets, or shield yourself from short-term volatility - dollar-cost averaging is for you.
With Endowus.com, you can LSI and DCA/RSP all your money - cash, CPF & SRS in globally diversified, intelligent, low cost portfolios seamlessly on online.