Updated: May 16, 2020
Dollar Cost Averaging (DCA) is an investing strategy in which an investor mades regular purchases of a targeted equity or asset at periodic intervals in the attempt to reduce the effects of volatility.
To put it simply as an example, it's the act of putting $1000 on STI ETF on every first trading day of the year regardless what the price of the STI ETF is. In this methodology, you also avoid attempting to time the market and hence avoid the mistake of making one lump sum purchase at a terrible price.
If you were to put DCA under a microscope, does it do equally well in both rising and falling markets? Apparently no.
A short article here highlight this. In a falling market, DCA triumphs. As the price of the equity keeps falling, the same sum which you invest at periodic intervals allows you to buy more and more shares of the equity and this reduces your average buy-in price as compared to lump sum investing. On the reverse, DCA is less effective in a rising market. As the price of the equity keeps rising, the same sum which you invest at periodic intervals allows you to buy less and less shares of the equity and this increases your average buy-in price as compared to lump sum investing.
Wait a minute. Does this means that we should now time the market even when doing DCA? The answer is no. While there is no doubt that DCA does better in falling market as compared to rising market, there is no sure tell sign whether the market is rising or falling on the next day. Bear in mind that the analysis above is done on hindsight, and you will always be able to make perfect trades in hindsight. When it comes to actual practice, no one can confidently tell you if the market will rise or fall the next day better than a cat. Hence it will be futile to try to time your DCA purchases as doing so will defeat the whole purpose of DCA.
The hardest part about DCA is that you have to be rational enough to stick to it. And that's where most people fail. The common argument here is that people tend to want to catch the bottom of the market. Maximum gains are made when you catch the bottom of the market and you can't blame people for wanting to do that since there is a good chance the price will be even lower in the next few weeks or even days. This put people in good faith that they can always buy the share at a cheaper price and they end up never buying it anyway.
In an attempt to compare between DCA and "catching the bottom", I decided to run these two different investing strategies on STI ETF for a time period from 2008-01-10 to 2020-04-21. (the earliest date I can get on STI ETF data from Yahoo Finance is 2008-01-10)
Investing Strategy 1 "DCA": Invest $1000 on the first trading day of each year from 2008 to 2020 (with the exception of 2008: bought on 2008-01-10 instead). All dividends are reinvested.
This is how the fund allocation for investing strategy 1 "DCA" looks like.
Investing Strategy 2 "Catching the bottom": Set aside $1000 every year from 2008 to 2020. Only invest the sum when a "market bottom" is reached (refer to graph below). The dividends are reinvested at the same time as the purchases of shares in respective years.
The market bottoms are defined as the significant lowest points as circled in the graph. Purchases of the shares will only be made on these lowest points. $1000 will be set aside every year from 2008 to 2020. If a market bottom is not reached in a particular year, the $1000 will be saved as cash and roll over to the subsequent year. This will repeat until a market bottom is reached and whatever that had been saved up till that point will be invested. Bear in mind this is a perfect "catching the bottom" scenario as this is based on hindsight.
Throughout the course of history from 2008 to 2019, this is how the fund allocation for investing strategy 2 "Catching the bottom" looks like.
Now, how do these two strategies compare against each other?
Investing strategy 2 "Catching the bottom" certainly do better than DCA here. But that is because we have perfectly captured all the market bottoms. In comparison, the DCA method does not require you to have perfect hindsight and yet it does do not too badly as compared to the other "Catching the bottom" strategy which is almost perfect in nature. For most of the years in the duration of this analysis, the value of the portfolio from DCA strategy is quite close to the value of the portfolio from the "Catching the bottom" strategy. The only time a bigger divergence has happened between the results of these two strategies is in the recent months as we have assumed that we managed to capture the market bottom successfully on 23rd March and that naturally cause a skew of results in the short term. Given a longer timer period till the end of the year, there is a good chance that the results from these two strategies might start to converge again.
All in all, what's important here is that a common and simple DCA strategy here actually do not fare too badly against another strategy which perfectly times the market. Now, we all know how difficult it is to time the market. It's not usual for us to miss the bottom of the market by days, weeks or even months. What will happen if we just miss the bottom by 15 trading days every time? Surely, the results shouldn't be too different?
You are wrong!
These are the results.
Just a mere 15 trading days miss from the market bottom has a bigger impact on the results than we thought. In fact, the results from "Catch the bottom + 15 trading days" is not too different from what we are getting via our DCA strategy!In the grand scheme of things, a 15 trading days difference from the absolute market bottom is a very short time period and most of us could already pat ourselves on the back if we could achieve such an accuracy in timing our purchases. However, the fact is most of us could probably not even achieve such an accuracy! And imagine all the work you have to do to just monitor the market to try to catch the market bottom. Even with all these efforts, your strategy simply do not fare too much better than a simple DCA strategy.
If you are not convinced, I plotted a few more lines for other strategies with varying degrees of days away from the absolute bottom as shown below.
They all tell the same story. The results from all of them do not differ too much from what you are getting from DCA strategy.
So what do all these data and results tell us?
If you are always sitting on the sidelines trying to catch the bottom, it's probably pointless to do so. You probably fail to catch the absolute bottom, and there's also a good chance that you are unable to beat the simple DCA strategy. I personally do not believe in catching the bottom, but I do believe in the use of trend investing. You may like to check out my other articles on trend investing: here and here.
Back to the original question of this article. Is DCA a good way to buy STI ETF?
Yes. If you are a novice investor or simply want an entirely passive investment strategy which provide you with reasonably good returns, DCAing into indexes (in this case STI) is absolutely a good strategy to consider. But do bear in mind you need to be absolutely disciplined and rational in your periodic purchases to ensure DCA works. And that is probably the most difficult part of the DCA strategy.
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