What is dollar cost averaging?
Dollar cost averaging is an investment technique used to reduce volatility risk.
This is done by splitting your capital into several parts, which is then used to invest in several intervals. For instance, instead of investing one shot $10,000 into a stock, I can choose to invest $2,000 into it for the next 5 consecutive months.
“The benefit of dollar cost averaging is that it forgives people who may buy a stock at the wrong time.”
As a retail investor, you may not know exactly when the price is low enough for a stock to be worth it to buy. Hence, instead of speculating or leaving to it to luck, you can easily invest on different occasions so that you can avoid buying a stock at an extremely high price.
This technique is especially useful in a bear market. This is because prices continually decrease in the long term during a bear market. As a result, you will not want to invest all at once at the start. You will prefer to invest slowly into the bear market to purchase a larger number of stocks with the same investment sum.
What talking you sia?
To illustrate this example, imagine you have $10,000. At first, the stock costs $10 per share. If you all-in straight away, you will buy 1000 shares in total.
“Next month, due to poor economic sentiments, the share price may have dropped to $5.”
If you had used dollar cost averaging, you will have chosen to split the $10,000 into half and buy the stock in the two months. The number of shares bought this way would have been 1500. This is easily 50% more in shares by using the same amount of capital, which is $10,000.
Seriously, so good?
Well, the sad thing is that DCA only works well in a bear market. History also tells us that bear markets only happen around 33% of the time in an economy. So, if you DCA all the way, you will theoretically lose 66% of the other time.
If not DCA, then what?
For a bull market, it makes more sense to do lump sum investing (LSI). With the same $10,000 this time round, it would be better to invest everything earlier as the share prices in a bull market will only go higher and higher, generally speaking.
So DCA or LSI?
Simply put, lump sum invest in a bull market and DCA in a bear market. Honestly, it is easier said than done.
Firstly, it is not easy to correctly determine a bull or bear market for a substantial period of time as market conditions change erratically.
“By the time you have decided to lump sum invest at the start of the bull market, the waiting time will already incur you opportunity costs.”
The money could have been invested earlier to collect dividends or gain capital appreciation. Worse still, the market may have turned for the worse and become bearish, forcing you to dollar cost average instead.
So what will SG Finance Guy do?
Personally for myself, I do not have large sums to lump sum invest in the first place. For the many people like myself who are still young and lack capital, the only choice left is to dollar cost average every month. Of course, you can always choose to reduce transaction fees by investing one shot, through accumulating enough capital.
“However, as a value investor, I am not disturbed as much by the prices I purchase stocks at. As Warren Buffet says ‘Price is what you pay, value is what you get‘.”
I will likely have already determined the stocks to rise in the long run due to their good underlying businesses. Hence, capital appreciations are almost always guaranteed in the long term.
“LSI or DCA, the right way to start is to invest early so that time is on your side.”