Dollar Cost Averaging vs. Lump Sum Investing
At NAOF, Dollar Cost Averaging (DCA) is often mentioned in articles and it has gained traction throughout the years due to its advantages. But is it better than lump sum investments? Liken to the famous analogy, this article discusses if we should put all our eggs into a basket at once or spread it out.
Dollar-Cost Average (DCA)
Have you bought a big item such as furniture or electronics to find that the price dropped in the following week? You end up lamenting the opportunity cost incurred. This is the same for stocks. Very often you would find yourself in a similar situation when it comes to investing. Immediately after purchasing the stock, it’s price collapses and you would be cursing your “bad luck”.
The emotional aspect of investing is exactly what a DCA approach seeks to remove.
What is DCA?
It is a passive investment strategy that advocates periodic investment into a particular counter regardless of price movements. Instead of putting a lump sum into the stock all at once, investments are divided into smaller tranches and made on a monthly or quarterly basis.
Back to the analogy given previously, the market has been on a rollercoaster ride ever since the pandemic started. Imagine putting all your savings into the market at once and seeing the counters you’ve purchased go on a 30% to 50% discount the following month!
Most new investors and (even some seasoned ones) will freak out and very often, their emotions will get the better of them, leading to a wrong decision made. As mentioned earlier, the DCA approach looks to remove that emotional aspect and “automate” the investment process/decision instead.
How does it work?
To illustrate the above, let’s take John as a simplified example. John has been looking at the markets and decided to set aside $6,000 for investments. Having seen the volatility of equities, he opted to split his investments into small tranches of $1,000 a month. Based on his income, he believes that this amount is manageable for him to set aside to continue averaging into the market.
If the market moved as the chart shown above for the following 6 months, this will be the investment he made:
By carrying out DCA approach and investing $1,000/month over 6 months, John would’ve accumulated 439 shares at an average price of $14.58.
If he was to adopt a lump-sum investing approach, he would have purchased 387 shares based on the initial cost of $15.50.
He would not have been able to accumulate more shares during the months of March and April when the share price of the counter was particularly weak.
This is one of the key benefits of DCA (more on that later). In general, DCA works better than lump-sum investing when the market is trending down or sideways but loses out to the former (in terms of returns) in an upmarket scenario.
Advantages and Disadvantages of DCA
By investing regardless of market movement, investors can average out their entry price to combat volatility. Here is what DCA helps to combat and what it may lack for investors:
Advantages:
- Discipline: DCA forces you to invest periodically regardless of market prices. Have you ever thought, “Market seems hot this month, maybe I’ll skip this month and double my investment in the coming one” and end up not investing at all? DCA allows investors to build a portfolio “automatically” in the long run.
- Overcome Emotions: Removes the emotional aspect of investing as DCA is a passive investment strategy. As your investments are spread out, a drop in prices is only an opportunity for you to accumulate more shares! The change in mindset reduces the investing mistakes that you might make.
- No Timing of Market: Time in the market always beats timing the market. As the market is highly volatile, buying into the market before its downturn can lead to heavy losses and opportunity costs.
- Lesser Volatility and Risk: As your investments will be averaged out throughout the months, you are not as sensitive to market volatility.
- Building of Portfolio: DCA also allows you to invest in smaller amounts and build a sizeable portfolio in the long run. This is exceptionally advantageous for students or young investors with lesser capital.
- Less Time Consuming: As you are immune from market volatility, this strategy requires less time and effort from investors.
- Low Cost: If you were to use platforms that provide DCA services, your transaction fees will be low and it allows automated reinvestment of dividends.
Disadvantages:
- The uptrend of the Market: If you were to look at the market’s performance for the decade, it has generally been on an uptrend. DCA may not be as ideal in situations as such. It begs to question, however, if the market will continue its uptrend but this is a million-dollar question that no one has got an absolute answer to.
- Longer Horizon: With DCA, it will take a longer time to build a sizeable portfolio compared to putting a lump sum into the market.
- High Cost: If done manually, transaction fees may be high and reinvestment of dividends can be costly.
Where can you DCA?
There are generally two ways for investors to carry out DCA.
- Manually in the market: Investors can do it manually in the market by making periodic investments. However, the transaction fees are generally high in this case.
- Through Robo-advisors or financial institutions: There has been an emergence of financial institutions providing DCA services at a lower fee. Through providers such as OCBC, FSMOne and Syfe, investors can gain access to individual counters, ETFs, and Unit Trust!
Is DCA ideal for you?
Many have viewed the market as more of a mental game than anything else due to the emotions that come into play. DCA is an ideal strategy to avoid emotions and market volatility.
If you have a small capital or is someone who just wants to engage a disciplined approach to invest regularly, then DCA will be the ideal strategy for you!
Additional Reading: The Untold Secret to the Best Time to Invest
Lump sum investment
On the other side of the coin, another investment strategy would be to make a lump sum investment into the market. This is unlike the DCA approach where you “divide” up your capital into smaller sums to be invested on a regular basis (say monthly).
What is Lump sum investment?
Instead of spreading out your investments, this strategy refers to putting all your eggs into a single basket at once. By doing so, your investments are riskier with a higher sensitivity to market volatility. With higher risk, investors are also rewarded with higher returns when entries are timed well.
However, entering before a market downturn can be “costly” for investors, especially when the emotional aspect of investing sets in, translating to poor investment decisions made.
How does it work?
Let’s take the same example mentioned above. John with a $6,000 budget to invest in the markets. Instead of splitting his investments into smaller tranches, he invested a lump sum into the market at the month’s closing price.
In the given scenario, lump-sum investment was able to outperform DCA for half the months. However, the amount of units he would’ve owned varies between the comparisons. To highlight the stark comparisons:
- In March, a lump sum investment would’ve given you 600 shares compared to 439 shares through DCA.
- In May, a lump sum investment would’ve only given you 285 shares compared to 439 shares through DCA.
This highlights the relative importance of timing the market well if one decides to engage a lump sum methodology when investing. However, timing the market is easier said than done. More often than not, investors will make wrong decisions (due to emotional/psychological effects) and end up taking losses on their investments.
Note that the stock market has historically trended higher over a long horizon. That is why I highlighted that the importance of timing the market is “relative” in nature. If you have got a long-time frame, then you should engage in lump-sum investing even if you are the worst market-timer in the world.
Those who are interested in lump-sum investing for the long-term can check out this article: How to become a millionaire even with the worst market timing.
Advantages and Disadvantages of Lump sum investment
Apart from having to time the market well, investors require the mental strength to withstand any market volatility. Here is what lump sum investment helps to combat and what it may lack for investors:
Advantages
- Higher Returns: In an uptrend market, lump-sum investments tend to outperform DCA. If timed well, this strategy will provide higher returns.
- Lower Costs: Fees are generally lower in the long run as the number of transactions is significantly lower than DCA
- Wider access to the market: Investors can invest a lump sum into any assets in the market. As for DCA, financial institutions provide a limited number of counters.
Disadvantages
- Requires higher capital: To enjoy meaningful returns, lump-sum investment requires higher capital at the initial stages of investment.
- Emotionally draining: Imagine investing $100,000 into the market all-at-once vs. splitting it up into 10 trances of $10,000. Which is more emotionally draining for you?
- Opportunity costs: As the market is highly dynamic, investors may incur opportunity costs if a lump sum investment is made. Other better opportunities may arise should the market correct and one will not be able to capitalize.
- Higher Risks: Without averaging one’s entry price, investors are exposed to greater volatility and losses.
Where can you do Lump sum investments?
Lump-sum investment can be easily done on any brokerage firm that you use. If you are still looking for a trading account, these are some companies you can consider – Tiger Brokers, DBS Vickers, and our analysis on the best brokerage firm in Singapore for 2021.
Is Lump sum investments ideal for you?
If you have a sizable capital/savings accumulated, coupled with a long investment horizon, then a lump-sum investment might be ideal for you. Compared to DCA that requires a longer horizon to build a portfolio to retire well, the lump-sum investment strategy allows you to “accumulate” one at a much faster rate.
However, be mindful that this strategy is more susceptible to market volatility and you must have an appetite for risks! If you are not one who “gets emotional” every time the market goes on a “roller-coaster” ride, then lump sum investing might be the cup of tea that generates you a higher return over your investment horizon.
Conclusion
Putting all the pointers together, I believe that your investment objectives and the horizon is critical in selecting the right strategy. If you are a student or someone that just started your career, the DCA methodology will be more suitable for you. The key is to get started on your investing journey ASAP, even if that entails a commitment of just $100 every month.
While the returns might not be substantial in the beginning, it is the action of getting started and “automating” your investment that will ultimately translate to long-term success.
Most people fail to even get started.
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Disclosure: The accuracy of the material found in this article cannot be guaranteed. Past performance is not an assurance of future results. This article is not to be construed as a recommendation to Buy or Sell any shares or derivative products and is solely for reference only.
