Dollar Cost Averaging (DCA) — To Average Or Not?

Dollar Cost Averaging (DCA) is not alien to most people. It is a nice sounding name for a simple regular fixed investment approach frequently sold to the retail mass. And it is sometimes touted as the panacea for flaws such as self screwing human emotions and futility of market timing in investments. I am sure many sat in talks on, or even bought into DCA type investment plans. Majority of these are pure equity or equity heavy plans. But, as discerning investors, rather than just take what the so called pundits said as the truth, we should look at it in more detail.

What is Dollar Cost Averaging (DCA)?

DCA is an approach where an investor invests a fixed amount of money periodically over time instead of pumping it in all in one shot. For instance, you can split $100,000 into $500 chunks and use it to purchase mutual funds or ETFs every month. And there you go, you got your own DCA investment program! With a fixed dollar amount each month, you will buy more shares or units when the price is low, and less when the price is high. And over time, your entry price averages out. You will not get the best price, but neither will you end up with the worst. The central idea is to spread out your bets to avoid concentrating everything at a single point in time. And hence, the name Dollar Cost Averaging.

Is Dollar Cost Averaging Your Miracle Formula?

For those who are not familiar with DCA, you should know by now that it is not some awfully complex concept. Like any other strategies conceived in history, DCA is not without its own flaws. But they are often overlooked. Many adopted this approach not because they do not have the money, but rather, breaking up a large investment into bite size makes it easier for them to stomach. On top of that, to make it easier to sell, there are professionals actively pushing the benefits of DCA as if it is a miracle solution. And what are some these claims?

1. Instill discipline and consistency to overcome emotions.

This is probably the only point I have no contention against. Under a DCA program, you are “forced” to put your money to work regardless of what you feel about the markets. And because you are only parting with a small amount each time, this takes stress off your mind. Under such conditions, you are less susceptible to emotion driven irrational decisions that can sabotage your efforts.

2. No one can time the market, so don’t time.

I agree with the statement in general. In fact, I alluded to the same point in my earlier post on investment philosophy : Your Market View Is Not As Important As You Think. But let’s be very clear about this. Not being able to time the market does not mean not timing it is your magic sure-win formula. Neither does it imply you are free of market timing element. People tend to focus on the averaging aspect of DCA, but forgot that this come with systematically increasing your position size and risk. A 20% move in the market late in the game has a lot more impact on your total portfolio than early on. With a DCA approach, you are just deferring your risk to a later stage and with each new investment, the averaging effect gets diluted.

3. DCA has a lower risk compared to a lump sum investment

That depends on the perspective you are coming from. If we are talking about volatility. Of course, it will be lower. That is a no brainer. Why? Because you are taking smaller risks and dialing it up gradually over time. A simple risk measure such as volatility is not meaningful enough. How a DCA performs boils down to how much downside it avoids against how much upside it gives up. With markets generally trending up and bulls outlasting bears, DCA tends to lag significantly behind the markets over the long term. But to be fair, we should adjust at least for risk e.g. Sharpe ratio.

DCA is highly dependent on the market path

Let’s see how DCA perform with respect to different scenarios. In order to highlight the points, I created fictional scenarios bordering on the extremes. Now, let’s get started. You have a $100,000 and are looking to invest and harvest your returns after 10 years. At this point, you are deciding between investing either through a single lump sum, or using a DCA approach. For the latter, you will put $10,000 to work at the start of each year over the 10 years. And in the meantime, let’s take it that the excess cash sitting around gives you 2% a year.

Scenario 1: Market moves up in a straight line

If market moves up in a straight line, it is pretty obvious that the DCA approach will lag behind since every purchase you make gets increasingly more expensive. But you will still make money.

Scenario 2: Market moves down in a straight line.

If the market moves down in a straight line, then it is also quite clear that DCA will outperforms. Because it picks up bargains along the way and loses less than the lump sum approach.

Scenario 3: Market moves down in the first 5 years then up the next 5 years.

This is the ideal scenario for a DCA approach. It loses less at the start as the risk is small. Then it capitalizes on the up move later as market recovers and its position piles up. So while the lump sum is below water in this scenario, DCA still holds up.

Scenario 4: Market moves up in the first 5 years then down the next 5 years.

This is the worst scenario for a DCA. It did not make much on the initial trend up as the position is small. And just when it builds up to a more decent size, market heads south and it takes a bigger hit.

Even without the tables and diagrams, it is not hard to visualize the scenarios. They are quite straightforward. But please do not get optimistic here thinking that DCA has a 50% chance to outperform simply because it has 2 favorable scenarios out of the 4. By doing that, you are assuming that each scenario has an equal probability of playing out. Given that stock markets generally rise over the long term, the scale seem more likely to tip in favor of a lump sum approach. Let’s see some real market action.

Real Market Action: DCA Vs Lump Sum

Let’s test it out on the US, Hong Kong and Japan stock markets from 1987 to end 2018. For simplicity, I will use the stock market price indices as proxies for market performance. Both dividends and transaction costs are excluded. And as per what I did for the scenarios earlier, let’s assume idle cash generates an annual return of 2% but this time compounded daily. For the DCA approach, you will split $100,000 into equal monthly amounts instead and invest them into the market at the start of each month.

US Market — S&P 500 (1987–2018)

US markets rose more than 10 times (excluding dividends) from 1987 to 2018. A single lump sum investment of $100,000 at the start of 1987 would turn into $1,035,161 at the end of 2018. This translates to a yearly compound return of 7.58%, a fairly decent figure. A DCA approach, on the other hand, ended up with $359,322 or a compound annual return of 4.08%.

In terms of risks as measured by volatility, DCA is indeed much lower. However, it is pointless to look at risk on its own. If we compare the Sharpe ratios instead, which gives the returns per unit risk, the lump sum approach still holds the upper hand. DCA’s draw down of more than 40% is also not that far off from the lump sum approach.

Hong Kong Market — Hang Seng 50

The Hong Kong market is lot more volatile than US, but the results are very similar. Like US, it has an overall up trend. Over the period from 1987 to 2018, Hang Seng also grew to more than 1000% of its starting value turning a lump sum of $100,000 to more than a $1 million. The compound annual returns stands at 7.52%. This is much better than the DCA approach yielding only 3.72% annualized return over the same period. Again, DCA also loses out on a risk adjusted basis.

Japan Market — Nikkei 225

Japan displays a different behavior from US or Hong Kong. Unlike US or Hong Kong, which have been on an up trend, Japan is the reverse as it went through an extended period of economic stagnation in the 90s. As at end 2018, it is still well below its peak in 1989. In fact, it barely made anything at all between 1987 and 2018. A lump sum investment in 1987 will make you a measly total return of 6% or an annualized return of 0.19% after more than 30 years. For those who are fixed with the notion that stock markets will always rise in the long term, you are probably right most of the time. However, do be aware that things can always go wrong and Japan is one example. And in this instance, DCA outmaneuver a lump sum approach.

Approach Investment With DCA’s Discipline And Lump Sum Perspective

It would seem that a lump sum investment trounces DCA in products that appreciate over the long term. And given that stock markets typically exhibits such a behavior, a lump sum approach looks like the way to go. But in practice, is this really the case?

DCA has its own merits. What we have considered are situations where you already have the money and are deciding between investing a significant lump sum or splitting it up using the DCA approach. But, one may not have the luxury of such a choice. It is not like everyone can write a $100,000 check anytime they want. Then the question to ask is “Do I start small now and invest at regular intervals or wait till I have sufficient money and then invest at one go?” This will then have a different implication. Waiting has a price and the longer it is, the less likely it will be in your favor.

Actually, DCA and lump sum does not have to mutually exclusive. We can instill the discipline of a DCA into a lump sum approach. In real life, your cash flows are likely to change and not going to come in all at one point in life. The important thing is to have a plan where you regularly examine and build up your investments. And why restrict ourselves to some fixed amount each time? Why not see things from a lump sum perspective and go with what works for you at that point in time taking into account your cash flow situation, investment horizon, objective and risk preference.

Originally published at investmentcache.com on March 9, 2019.