We’ve all heard the timeless investing advice of not trying to second-guess the market and instead adhere to the mindset that “time in the market beats timing the market”.
It’s true. Staying invested in the stock market – instead of trading in and out of it frequently – results in better long-term returns.
But what about how you become invested in the stock market. Putting money into the stock market through dollar cost averaging (DCA) is one of the best ways to take emotion out of the equation.
Here are some of the pros and cons to taking a DCA approach to investing.
When we invest, one of the worst things we can let happen is to allow our emotions to control our decisions.
That’s where DCA investing comes in. It allows you to invest a certain amount of money every month (preferably on the same day each month) so that the “timing” aspect of investing is taken out of the equation.
Of course, this requires strict discipline on the part of the investor to ensure that money is invested each month over a certain period of time.
It’s also important to make the distinction between investing in an exchange-traded fund (ETF) that tracks broad stock market indices – like the S&P 500 – versus buying individual stocks.
That’s because stock markets as a whole rise over time but with individual stocks, you need to follow them closely to ensure the business is performing up to your expectations.
If you happen to average down into a losing stock, via DCA, then it will do you no favours over the long term.
Buying into a down market
One of the accepted advantages of DCA investing – versus lump sum investing – is that if stock markets are falling, or depressed, for a sustained period of time then DCA investing is a preferable option.
For example, in the US between 2000-2010 – one of the worst decades on record for returns given it included the Dot-com Crash and the Global Financial Crisis – a DCA approach to investing in the S&P 500 would have beaten a lump-sum invested (LSI) amount in 2000 (see below).
That’s because there’s always the fear of buying a significant amount “at the top” before the market crashes.
In that sense, DCA investing allows you to average down on the index as it falls before also participating in the rally.
Structural bull markets are less favourable
However, the reverse is also true in that if your investment starting point is at the bottom of a bear market then DCA investing will underperform lump sum investing over the long term.
That’s because averaging into a rising market over time means less value for money. However, no one can predict the direction of the market.
Yet if you had had the courage to pull the trigger and buy big into the S&P 500 close to the bottom in early 2009, then your returns over the subsequent years would have easily beaten a DCA approach (see below).
And the above chart was only up to the beginning of 2018 – so you can imagine how much further stock market prices have climbed since.
At the end of the day, DCA investing is a great way to ensure that you’re disciplined in your approach to investing.
It may not equate to outsized returns versus lump sum investing in certain scenarios but it will allow you to participate in the wealth building process, no matter what the stock market is doing.
There are also no rules stating that investors can’t combine both DCA and lump sum investing in their approach, with perhaps monthly amounts complemented by a lump sum investment when you receive a work bonus or when you see there is a sharp sell-off that creates a compelling opportunity to buy.
Either way, DCA investing provides a great method, for both experienced and beginner investors alike, to ensure that emotions don’t control their investment decision making process.
Tim, based in Singapore but from Hong Kong, caught the investing bug as a teenager and is a passionate advocate of responsible long-term investing as a great way to build wealth.
He has worked in various content roles at Schroders and the Motley Fool, with a focus on Asian stocks, but believes in buying great businesses – wherever they may be. He is also a certified SGX Academy Trainer.
In his spare time, Tim enjoys running after his two young sons, playing football and practicing yoga.