There are a wealth of articles and advertisements out today espousing the benefits of averaging investment cost through a Dollar Cost Averaging Plan (DCA). These headlines purport that DCAs also offer a reduced investment risk, compared with a lump sum investment. They go on to describe how putting money in a DCA as a long-term investment will enable you to buy stocks at lower prices. When the stock market goes up, the investment return should surpass those from a single investment plan, right?
Think again. Regardless of these assurances, DCAs still lose money after a long-term investment. Let’s look at three main reasons.
The longer you invest through DCA, the benefit of averaging cost vanishes
Consider this DCA: You’ve been investing in Fidelty 500 Index Fund (FXAIX) for 1,000 per month for different spans of time up to now (04/01/2019). If the price of the last period falls 30% (about half of the loss experienced during the financial crisis of 2008), how might it affect our total costs and profits between these investment time spans?
Take a look at the blue bar of Fig. 1 to notice the effects of this drop. If the price from last period drops sharply by 30%, it will cut 8.99% from the cost of investing 3 months, 4.86% from the cost of investing 6 months, 2.75% from the cost of investing one year, and 0.56% from the cost of investing 3 years. Investing with DCA can very well average cost compared with lump-sum investment, but over the long term the effects of averaging cost becomes more and more insignificant. After 3 years investing with DCA, nearly all of the benefits of averaging cost are gone. After such a long term investment, the time at which you begin investment has a tremendous effect over the average cost for both investment strategies.
On the contrary, the fall in stock price has a significant effect on total profit. The effects can be seen in the orange bar of Fig. 1. With the assumption that stock price drops 30% in the last period, the loss when investing 3 months is 21.25%, 6 months is 22.58%, 1 year is 24.84%. Your loss on SIP is primarily affected by the time you began to invest.
Invest in the wrong markets and your losses will never recover
The public media often espouse on the tremendous performance or the trend may fall in some markets to encourage investors to buy for averaging cost. Investors that follow this trend would see massive gains after the market goes up.
Let’s compare the performance of different markets for the ten years after the financial crisis of 2008. We chose the top 5 outperforming markets on a 5 year return after the crisis and then for investing another 5 years. Compare the 5 year total returns on DCA and lump-sum investment in the following table:
The table below also lists the top 5 outperforming markets on total return from the previous. Compared with the previous table, the ranks and markets are totally different.
Nearly all stock markets in the world became bull markets after the financial crisis. The top outperforming market was Thailand 5 years after the crisis. But the top outperforming market was the US within the past 5 years. If you chose the second outperforming market – Sweden in 2014 – to invest, the lump-sum total return was nearly zero. We can realize just how unpredictable the stock markets are from the previous tables.
- Choosing which markets to invest in based on their past performance doesn’t represent future performance. Even worse, it represents an inverse indicator.
- Compared with lump-sum investment, a SIP does not perform better in an upward trending, it actually performs even worse.
DCA only performs better in the upturn markets
After all of this you must be asking, what kinds of stock markets with different trends make DCA outperform lump-sum investments? Here’s an example by the Europe Stock Market – iShares Europe ETF (IEV). We can classify stock market trends by the shape of the accumulated return for 6 different types: Trend upward, Trend downward, Trend upward then downward, Trend downward then upward, Trend upward shortly then downward, Trend downward shortly then upward. If we invest for one and a half years in all 6 of these trends in a DCA and a lump-sum, which outperforms the other?
From the descriptions and data shown above, we can come to some solid conclusions. The top performing trend of the market for DCA is trend downward then upward. But for all other trends, DCA does not outperform compared with a lump-sum investment.
What did we learn? Choosing an opportune time in the right market to invest is the best way to achieve an outperforming return. This return is not related to whether we choose one over the other. Yet to predict the market successfully is clearly the most difficult and intriguing challenge in the history of the stock market. Is there any strategy that would allow me to systematically operate my investment to average cost more efficiently? A fixed allocation percentage strategy would be a better choice.