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 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 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, you stay committed to investing that $1,000 on the 1st of every month.
For beginner investors, 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.
One of the common misconceptions people have is that they want to put off investing until they have accumulated a "large enough" nest egg. This is not true. The sooner you start building up an investment portfolio and the longer you stay invested, the more likely you are to reap the benefits and grow your wealth
With dollar-cost averaging, you don't have to start with a sizeable sum. In the long run, the cumulative value of the investment will grow, boosted by the power of compounding.
The routine of dollar-cost averaging also 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.
Lump-sum investing (LSI) 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.
How do their returns differ?
Mathematically speaking, investing a lump sum gives you higher returns than dollar-cost averaging. 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 lump-sum investing versus 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 dollar-cost averaging 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 dollar-cost averaging outperformed lump-sum investing, and as you can see, dollar-cost averaging 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.
Investing through dollar-cost averaging appeals in a downturn
However, these 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 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.
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 research 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).
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 LSI and DCA/RSP all your money — cash, CPF, & SRS — in globally diversified, intelligent, low-cost portfolios seamlessly. To get started, click here.
Investment involves risk. The value of investments and the income from them can go down as well as up, and you may not get the full amount you invested. Past performance is not an indicator nor a guarantee of future performance. Rates of exchange may cause the value of investments to go up or down. Individual stock performance does not represent the return of a fund.
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