Asked on 06 Oct 2019
Doesn’t sound right to me though - if you start DCA at the peak, it could go on for a few months to years and given speculation on a recession in the next few months etc, does opportunity cost of not being in the market now really outweigh the pros of waiting for prices to appear much lower before going in? Or no difference?
Hi anon, to put things in perspective here, we need to consider a few things:
Do you know when the market peak is? Fact is, no one does. However, if you stay out of the market because you think it is at the peak and you are waiting for the bottom, it is very likely that you will continue to stay out because of fear that the time is 'not right'.
DCA will work best when you have a long enough time frame. There is a Straits Times article behind a paywall, but I will link you to the chart here (which is based on back-tested info): https://www.straitstimes.com/sites/default/files/attachments/2018/04/15/st_20180415_bizltdca15a_3909132.pdf What do you notice? We are looking at a timeframe of years on all the charts. Even in a U-shaped market, it takes 5 years for the market to return to where it was prior to the crisis. During the period where the market was headed south, it takes considerable nerve to enter the market, as your psychological frame of mind will likely be in a state of fear that it can go lower (if you aren't in that state of fear, then that's good for you, but it is not a common thing for most people looking to invest)
But if you DCA, you will just go in the market without looking at the timing, and just hold your investments through the market cycle.
Let's examine DCA at the peak (top chart), entering at the peak over 2 years via DCA leads to a smaller loss compared to going in at the start with a lump sum (e.g. if you entered at the wrong timing). Consider this as averaging down.
On the 2nd chart, assuming you entered at the start of the graph thinking that prices were at a low already, you would only recover to your initial capital after 5 years. But with DCA, you would be in profit already.
On the 3rd chart, entering at the start of the graph thinking that it was the low, then you would be right and rake in a substantial profit over time. However, DCA doesn't do too badly either, turning a profit over the same time frame.
(Edit: I just want to point out that if you have 100K right away, and you are certain the market will be in a bull run, then definitely don't DCA. Just go all in. But the fact is, how many of us have 100K just like that? We are more likely to invest out of our cash flow, which is to say we will have 100K to invest, but that is over 100 months at 1K/mth as we work and earn and set aside money.)
I personally have seen the effects of DCA on my own UT investments, with the U-shaped market from Feb 2018 till May 2019. Through this period, I continued to DCA into a balanced APAC Ex-Japan fund and was having a capital loss till the market turned around this year, after which I turned a profit even though the APAC market hasn't exactly returned to the peak in Feb 2018.
I hope that has given you some insights and perspective. Naturally, I also have a warchest that will be deployed when markets are down more than usual. I am of course incurring opportunity cost not investing my warchest, so I am keeping it in high interest savings accounts to mitigate my cost.
06 Oct 2019
06 Oct 2019
Elijah gave a wonderful answer but I just want to emphasise on one thing.
The reason why we subscribe to DCA is purely because we don't know how the market behaves. We just can't truly predict it.
We don't know if it is currently at its peak or at its rock bottom. We don't know if it'll continue going up over the next 2 to 3 years, or go down during the same period.
However, it is still good to buy more when markets are on sale. So it shouldn't be DCA or Lumpsum, but a bit of both. You should set up a regular amount that you're comfortable with investing every month, but keep some money on the side for additional top-ups and markets look good to enter.
This way you don't miss out on any best days, and still, get to earn from market rebounds. There have been studies that show that if you miss out on just a dozen of the best trading days of the year, you would less than half of the year's total return. So staying invested allows us to not miss out on these peak days.
And the great thing about DCA is that when markets are either up or down, it is still good. You buy more when markets are down and when markets go up, well you're happy because your existing investment is doing well.
However, there's one investment where DCA may not make too much sense. And that is for non-volatile assets. It doesn't make too much sense to split a 10k investment into 1k over 10 months just to purposely 'DCA' especially if each investment has a purchase/trading cost.
At the end of the day, what matters most is the performance of the underlying stock/stock index you buy. No point DCA-ing into a volatile stock that had an overall downward trend for the next 5-10 years, you will just be buying into higher lows and lower lows. Over a long bearish investing horizon , each subsequent contribution will only constitute a smaller percentage of that counter, diminishing the effect of averaging down. Look at all the OSV counters (POSH, pacific radiance) that were Sg stock darlings before 2015 oil price crash, does DCA/time in the market help to alleviate permanent stock losses of fundamentally weak companies?
For stocks with a stellar, proven track record (disney, jnj, nike, mcd, microsoft etc) of consistently increasing its returns (capital appreciation+dividends), and you are confident in holding them long-term, by all means DCA/time in market.
However, stocks that are of a riskier nature (commodites, sin stocks etc), a more conservative approach for me is to first time the market entry price and then DCA if need be.
I think that time in market outweights timing the market because of the time horizon of the investment. If you are familiar with the Efficient Market Hypothesis (where all information about a trade will be reflected in the price of the stock), timing the market will be akin to assuming that the Efficient Market Hypothesis does not hold as you are waiting for that key moment to buy low and sell when it is high. The nature of these trades are that they are relatively short-termed as compared to "time in market" approaches and this could mean many years in the market.
As you mentioned, in the "unfortunate" event that you started off DCA-ing at the "peak", you seem to have automatically make a "loss" but there is no guarantee that the "peak" is the highest that it will ever be. However, you can never be sure that there will never be a higher peak afterwards. The spirit of DCA is in hopes that your average price of buying into the market is superior simply by averaging out the higher prices ("bad" purchases) and the lower prices ("good" purchases). I think it is also nice to note that lump sum investments do better than DCA if you expect the markets to be bullish! However, if you have a regular stream of small capital, DCA might be the way to go!
To add on to the answers provided by various established individuals here, one of the other reason we DCA is also because for many individuals, one does not simply have the time or other resources to repeatedly attempt to watch trends on a daily basis, or predict market movements effectively. By DCA, we allow ourselves to mainly focus on the fundamentals of the company.
Just a disclaimer, even with DCA, doing your own diligence is still important! Focus on the fundamentals of the company and its place in the market.
First of all, decide your time horizon and design a diversified portfolio. If you have a truly diversified portfolio then assuming no foreknowledge, you are better off investing lumpsum in it. This will put money into low correlated assets which means some will be at higher prices and some at low. Then rebalance lumpsum at regular intervals. This assumes you have designed your portfolio correctly and you don't have an educated view about the markets.
If you have an educated view about markets, you can attempt to wait for a dip to buy. It is a calculated risk you have to take for that extra bit of return. For example, the US market is at quite a high valuation currently. If your time horizon is long, and current valuations don't seem to meet your return expectations, then you could wait it out and buy only on dips. Or buy a substitute market within the same asset class to preserve diversification while you wait and watch.
I'm not a fan of DCA - I think it's good only if you have cashflow constraints. There have been studies comparing lumpsum and DCA, you can google it.
The fact remains though - there are other things to get right before you think about DCA - your time horizon, and your portfolio design.