Another advantage of Dollar Cost Averaging (DCA) is that it may better promote investing discipline than Lump Sum. What is “investing discipline”? How is it beneficial for investors in building wealth?
“What is ‘investing discipline’? Is that not the same thing as ‘consistency’?”
Investing discipline and consistency are related. But there are a few important differences.
In a perfect world, investors create comprehensive investor profiles that drive target asset allocations that reflect the individual’s unique circumstances. That leads to creating a personalized investment portfolio. One that is built in a structured way over time.
In the real world, this often does not happen.
Now, DCA may not assist in the target asset allocation. But it can help you better “stay the course” in building a structured investment portfolio.
“How can DCA help me improve my investing patterns and behavioural issues?”
If you intend to invest $400 per month into your asset allocation. That is consistency.
The DCA discipline factor is in “staying the course” during real or expected turbulence.
Maybe markets are at all-time highs and you are worried about a correction. If you think markets are overheated, should you invest that $400 or wait until after the crash?
Maybe everyone is buying heavily into a stock or sector and you have a “Fear of Missing Out”. Should you also jump on board the hype train?
Emotions and outside influences can easily creep into investment decisions. Causing you to deviate from planned funding patterns. Adhering to a disciplined investing plan will help minimize that side of the equation.
It will keep your investing consistency by being disciplined.
As an added bonus, your increased investing knowledge will also help maintain your discipline. How often, in previous episodes, can we seen that the ability to properly time market fluctuations is poor.
Even for investment professionals who actively manage portfolios. It is actually difficult to pick winners and losers and time markets. As well, we saw that missing out on only 5 or 30 of the best days, leads to significant negative impact on returns. That understanding of investing realities will also help you better “stay the course” when your gut is begging you otherwise.
“What other things can help maintain discipline?”
We will review investment quality in a future episode, but that is a big factor in maintaining discipline.
Part of the discipline breakdown relates to (perceived) poor investments or ones that have reached their peaks or valleys. Should I sell? If so, invest in what? Should I buy more in a down market as this asset will rebound? Or should I sell because it will never return to its previous value?
Investing in quality assets reduces these concerns. Now, what is a quality asset? That is the question we will cover later this month.
Another potential advantage of Dollar Cost Averaging (DCA) versus Lump Sum investing is consistency. DCA helps investors promote a more consistent investment approach. Crucial for long-term investment success. But a characteristic lacking in too many investor philosophies and strategies.
“Does that mean that all Lump Sum investors are inconsistent?”
No. Although there is a higher probability of inconsistent investing under Lump Sum.
With Lump Sum, there are three approaches.
You already have cash on hand. You review different investment options and invest 100% on day 1.
You need to accumulate cash over 3, 6, 9 months. Once you reach a critical mass, you research investments, and then invest 100% at that point.
You have identified an investment you wish to purchase. You then accumulate cash over time and invest 100% when you reach a critical mass.
The first option is best, though most investors do not have excess cash sitting there to invest. Option two is more common. You decide to invest, start saving, then find the “best” investment when you have saved enough cash. Option three is also common. The problem is that if it takes 12 months to amass capital, is it still the “best” investment a year out? Investors should do another review before buying.
Now, yes, investors using these strategies can be consistent. But life often gets in the way. As they are saving to invest, maybe the car breaks down. It is a cold winter and that $3000 you have already saved can help pay for a Hawaiian vacation.
Now compare that with simply setting aside $200 per month and investing every month or two.
In the real world, which approach will prove more consistent for most individuals over time?
“Can you explain more about behavioural investing and DCA?”
Part of investor behaviour is discussed above. Will investors have the will-power to save and consistently make Lump Sum purchases?
On the other side, DCA should become more like your utilities or cable bill. It is just another monthly expense that you adjust to over time. Hopefully, one that becomes painless in a year.
The amount contributed can be relatively low in your early years. But increase as disposable income rises. Again, DCA takes away human behaviour and promotes consistency.
“DCA really seems like a “no-brainer” approach to easily build wealth. Is it?”
Easy, yes. A “no-brainer”, not quite.
That is a problem for some DCA investors. They just set up an investing program, contribute on a consistent basis, and forget about it until maturity.
Even investing in well-diversified, low-cost, index funds requires continuing maintenance. Over time, your overall asset allocation will be out of sync with your planned target allocation. Depending on your personal circumstances, your target asset allocation may need adjustment.
Perhaps that “best in class” fund that you researched and started investing in 10 years ago is no longer high quality. New, improved products always come along that bear comparing. Maybe your wealth has increased and you should add other complementary products to your original portfolio foundation.
And so on.
Yes, DCA is useful and promotes a consistent investment approach. But there is more to the investment process than just ongoing funding. We will cover portfolio reviews and rebalancing in future episodes.
A potential advantage of Dollar Cost Averaging (DCA) versus Lump Sum investing is that it may benefit “smaller” investors. That is, individuals without extensive investment portfolios nor having excess cash on hand to invest 100% on day 1. While Lump Sum may theoretically provide better performance, the reality is that investors tend not to be able to invest everything up front.
You are talking to your local golf pro and she mentions a great stock to invest in. Do you have $5000 or $10,000 sitting in your bank account to immediately purchase shares?
Or, is your investment portfolio of sufficient size and diversity that you can quickly sell one of your underperforming holdings to invest in this new opportunity?
If the answers are “not really”, you are a smaller investor.
If I look at the RRSP bank-loan business in February each year, very few investors have excess cash available for purchasing new investments. Small investors are the norm, not the exception.
“So Lump Sum may not be practical for most investors?”
Yes. At least in the way most studies compare Lump Sum to DCA.
Studies tend to compare buying 100% of an asset on (say) January 1, 2018 versus buying in equal portions over (say) 24 months. Maybe that is $12,000 up front versus $2000 very second month for two years. In those studies Lump Sum tends to win out.
However, most investors do not have $12,000 sitting there just waiting to be invested. If you need to save for 6-9 months before being able to invest, you should factor that into the calculations.
There is also the opportunity cost in what you did with your finances during that two year period. Did you borrow to be able to buy 100% on day 1? Did you forgo other opportunities or incur other costs, just to have the $12,000 available? What about the lost return on any assets you liquidated to invest?
Might it have been better on your life to invest $1000 per month or $2000 bi-monthly over two years?
“How does DCA and behavioural finance impact the ‘smaller’ investor?”
We will also discuss this in future episodes. As DCA is very much related to investor behaviour.
DCA promotes good investing practice, especially for investors with limited capital. If investors use DCA, they may begin to make automatic deposits on periodic bases. If you consistently invest $200 a month, you may feel the financial pain for a month or three. But then it becomes like your internet, cell phone, rent, etc. You adjust in other lifestyle areas and do not notice the deductions.
Investing becomes more of a painless process. Rather than scrambling to find lump sums to invest.
“Can I actually invest with $200 per month?”
Maybe. Maybe not. It depends on the investments.
DCA is well suited to passive investing. If you buy index mutual funds, you should not pay transaction costs. And most fund companies allow for subsequent purchases in very low dollar amounts. Perhaps $500 or $1000 minimum on the initial investment, with subsequent investments as low as $50 or $100.
If you purchase exchange traded funds (ETFs), they may have lower annual costs than mutual funds. Not always. But often. However, you will pay a (say) $9.99 broker transaction fee on every purchase. If you are investing $100 at a time, you do not want to pay $10 in broker fees.
To reduce costs, you can store your periodic deposits in your investment account. Then purchase when you have a critical mass. Or, there may be so-called “no-transaction fee” ETFs available from your online broker. That eliminates the fee to buy or sell. Though, there are potential pitfalls with these “no-transaction fee” offerings.
For more information on this overall topic, please read “Investors and Dollar Cost Averaging”. We will also discuss how DCA promotes investing consistency, discipline, diversity, and quality, in the coming episodes. Topics that are crucial for any investor, but especially those with limited capital.
In Episode 44, it seemed that Lump Sum investing is superior to Dollar Cost Averaging (DCA). One aspect was the ability to actively time asset and market fluctuations under a Lump Sum approach. However, DCA does help investors to smooth market volatility and better manage investment risk in their portfolios.
Smoothing market volatility versus actively timing fluctuations. Which is more prudent for investors?
“In the long run, Lump Sum tends to outperform DCA. What about shorter time periods?”
That is a big problem with Lump Sum. Over short to medium time periods, there can be lengthy down markets or substantial price volatility. As we see in the video, short to medium may be 5-20 years before the markets recover to where they were post-crash.
Short given that the markets have been around for more than a century. But quite lengthy for the average investor if they invest 100% at a peak.
“Lump Sum may work in the longer term. But what about meeting my short term objectives?”
This is a related issue to the first point.
If you are 20-30 years old and your only investment objective is to accumulate wealth until retirement, you may have 40 plus years before beginning to draw down invested capital. That lengthy time frame allows younger investors to withstand market volatility, even if it is prolonged.
This is why younger investors tend to focus on higher risk (with higher return) assets.
But, even for younger investors, not all financial objectives have 40 year horizons. What about saving to buy a home in 3 years? Your child’s education in 10? Or, you are now in your late 50s and retirement needs may be 15 years away?
Had you bought into the Dow Jones Index in 1965, it would have taken until 1983 before it began to appreciate in value. With lots of volatility in that period.
The same is true in late 2008. Had you been fully invested back in 2000, all your gains would have been gone. And it would take until 2012 before recovering.
For those whose financial objectives matured in that time frame, they may not have experienced any positive returns.
“Why do professional asset managers not exploit short terms market peaks and troughs?”
That is the question.
We covered some of the data in “Episode 38: Investor Behaviour”. It is amazing how just a few days of missing market moves upwards can negatively impact portfolio growth. Even strong money managers will have difficulties exactly picking the “right” time to enter and exit markets.
Add in a variety of other factors. If you ever watch the “talking heads” on television. How often do they correctly predict market changes? Not as much as the non-professional believes they do.
Or behavioural factors, such as “herd mentality”, that may lock most analysts and money managers into a tight box. For example, 10 analysts cover a company. Consensus Earnings Per Share (EPS) for the next year is $5.00 per share and the consensus share price is $200. You see that 9 of the analysts are in a tight band, between $4.75 and 5.25 EPS. Yet the 10th analyst forecasts $1.00 EPS and a $40 share price.
Now, if analyst 10 is correct, a star may be born. Though analysts tend to only be as good as their last forecast. However, if analyst 10 is wrong, Starbucks may have a new barista.
So, what tends to happen in the real world, is that the analysts fall in line. Analyst 10 may forecast a little light, but will be much closer to the consensus. And what happens if the actual EPS is $1.00? Nothing. Analyst 10 just tells his boss that it was the company’s fault. His analysis was accurate. Just look at how 9 other analysts came up with pretty much the exact same conclusions. Bonuses for all!
And yes, there are a few analysts that have built a reputation for contrarian opinions. Marc “Dr. Doom” Faber is one who always comes to mind. But, it is often better to stay within the herd, rather than get picked off one by one for faulty predictions no one else agrees with.
“How can DCA help me manage my investment risk?”
DCA does exactly what is says. It builds an investment portfolio by dollar cost averaging over time.
You invest a fixed dollar amount on a periodic basis. Say, $1000 (plus $10 transaction fee) every 3 months.
Perhaps a stock trades at $100 on January 1, 2019. Your $1000 gets you 10 shares. April 1, the stock trades at $125. You can only purchase 8 shares. July 1, the stock trades at $90.91 and you buy 11 shares. October 1, it trades at $83.33 and you buy 12 shares. On December 31, the share price is $110.
Had you been able to invest $4000 in a single lump on January 1, you would have 40 shares with a value of $4400. For a nice gain of 10%.
Had you used DCA, you would have bought proportionately fewer shares in up markets and more shares while they were “on sale” in a down. Under DCA, you would have 41 shares instead of 40 at year end.
A simple example. In an up market, under DCA you would have less than 40 shares. Regardless, it does help smooth out asset volatility (i.e., investment risk).
From the data in the video, you can see markets (nor assets) seldom appreciate in a straight line. Smoothing out market volatility may be more prudent than trying to actively time market fluctuations.
For a little more information on this sub-topic, please refer to “Why Use Dollar Cost Averaging?”. We will also flesh out how DCA helps manage portfolio risk in subsequent episodes.
Another issue is funding. In the real world, few investors have cash sitting around on January 1 to finance an initial lump sum investment. That lack of ready capital is also a potential positive for DCA. Something we will discuss in “Episode 46: DCA: ‘Smaller’ Investors”.
What are the advantages of a Lump Sum investment strategy versus Dollar Cost Averaging (DCA)? A comparison of long-term asset performance, the ability to actively time markets, and transaction fees.
“Assets appreciate over time. So the sooner I invest, the better. Right?”
Yes, investable assets have historically appreciated over the long run. That is a big argument for Lump Sum. You invest 100% on day one, then let the wealth accumulate.
Under a DCA strategy, you may spread out your purchases over many months. The less time you own the asset, the less time it can grow.
Of course, in the short to medium term, markets do experience significant volatility. Which may temper the benefits of investing everything up front.
“Is Lump Sum investing better for investors who like to actively time markets?”
Yes. In the short to medium term, financial markets can be quite volatile. If you possess the market timing skills to exit at short term peaks and reinvest at the troughs, then lump sum works very well.
Of course, the inability for professional money managers to accurately time markets is a key factor in their habitual underperformance versus benchmarks.
We discussed this issue in “Episode 38: Investor Behavior”. Even being out of the market for only the 5 or 30 best days out of 13,870, had a substantial negative impact on asset growth.
“What about investment fees and expenses under a Lump Sum approach?”
Transaction costs tend to be lower under a Lump Sum strategy.
Perhaps you have $12,000. With Lump Sum, you invest everything at once. Most online brokers today charge flat fees, regardless of volume traded. That $12,000 invested in 1200 shares of ABC will cost you (say) $10 in transaction fees.
However, if you spread that purchase equally over 12 months, using DCA at $1000 each month, then you will pay $120 in fees. If you want to purchase $500 monthly over 24 months, fees rise to $240. That can add up in a hurry, especially for smaller investors who may only be able to invest $100 each period.
“Why is there a debate on this?”
Good question.
In the long run, Lump Sum should outperform DCA. It may be preferable for active investors who like to time market fluctuations. And Lump Sum tends to have lower transaction costs, something that is important for investing success.