Dollar-cost averaging (DCA) is controversial. We at Morningstar have dispelled the myth that DCA outperforms lump sum investing. However, personal finance is often more about the ‘personal’ than the ‘finance’. A lot of investors may get a sense of psychological safety from investing a little at a time, rather than investing all at once, Morningstar’s director of personal finance Christine Benz points out in her piece in defence of dollar cost averaging.
She gives three reasons arguing why dollar-cost averaging is still a sound strategy for most investors:
- Most People Don't Have Lump Sums: At the most basic level, most people simply don't have lump sums to invest, and if they do, it's a good bet they amassed a lump sum by holding off on investing it in the market or by pulling out funds that were once invested in long-term assets. Such maneuvers run counter to the research in support of lump-sum investing.
- Psychology: An equally important factor is that dollar-cost averaging can help investors overcome some of the psychological impediments that can bedevil investors, especially the difficulty of staying disciplined with their investment programs in tough markets.
- A Valuable Tool in Frothy (or Worse) Markets: Finally, even for investors who are sold on the research supporting lump-sum investing, dollar-cost averaging can prove a valuable tool in declining markets.
This debate recently surfaced on the r/PersonalFinanceCanada community on Reddit, where original poster (OP) u/fire_whale asked about ‘Buying the Dip’ vs Dollar Cost Averaging. Here is what the OP said:
“I’m 20 years old and I’ve been investing in VEQT for the last 1.5 years. I have deposited around $15k into my TSFA. My goal is to invest in low risk and long term ETFs such as VEQT so that I can have a more relaxed work like in my 40s and hopefully retire by 55. Up until now I’ve been contributing as much as I can into my TSFA and buying shares of VEQT when ever I get paid which is usually weekly/bi-weekly.
So technically I’ve been lump sum investing not dollar cost averaging because whatever available amount I have, I invest it right away. Dollar cost averaging is when you take a certain amount that you are able to invest and spreading it out periodically within a certain time frame. But I’m actually investing all that I can (after paying off my CC and putting some in my emergency fund) right when I can.
Anyways, does it make sense to now change my investing execution and only buy VEQT when the markets down?”
Reddit had a mixed bag of responses. Here are some:
Reddit Canada on Buy-the-Dip Vs Dollar Cost Averaging
"Lower" risk. And with VEQT, you don't need any other holdings since it owns it all. So you want to time the markets? What if there has been 2 week and the markets haven't gone down, now you missed some growth. Don't try and time the markets.
u/FelixYYZ
Time in the market > timing the market
u/Saint017
I generally prefer buying the dip rather than dollar-cost averaging, especially if I'm confident in the stock's performance. I find that if I take advantage of market lows, I can see much bigger gains.
u/buana881
I tried buying the dips for 10 years. I was never able to make it worth my while, I would have been better off DCA-ing the whole time. Even when I timed the dips perfectly (which I did a few times) I still lost out on more gains by sitting on the sidelines for too long. DCA. Don’t try to time the market.
I would consider bi-weekly investing to be dollar cost averaging. You'll end up buying every major "dip" anyways.
If you know exactly when the dip is please share. I've never met someone with a crystal ball before!
Of course, it makes sense to buy when the market is down. It's actually pretty obvious when you think about it. I bulk buy cheese when it's on sale, why wouldn't I do the same for stocks? The hard part is knowing when the market is in a "dip". If you can beat the market 7/10 times, I'll hire you as my investment advisor.
Just buy whenever you can. I also had the same thought as you when I regretted putting a lump sum into VEQT last week only to see it go down the next day (Last Friday) to this Monday. Then it went gradually back up again so I'm in the green once more. So, the formula goes like this, if you're investing for the long term, just buy whenever.
u/Diathise
I DCA on purpose because it makes me feel better, but lumpsum likely wins out long run
What Does Morningstar Think of Reddit Canada’s Advice?
Morningstar’s Director of Investment Research Ian Tam started off by saying, “Let’s recognize the fact that diligently pouring excess savings into a tax-sheltered investment account and then buying a low-cost global index fund has the OP farther along that most Canadians. Hats off to you OP!”
He then adds that, “The question between dollar cost averaging and lump sum investing has been discussed and researched in detail at Morningstar. In a nutshell, if equity markets continue to rise over the long term, as they have historically, then lump sum investing simply affords higher returns over long time periods because of the effects of compounding. This said, the OP hit the nail on the head, there is a large a psychological element involved, especially if you are a skittish investor. Make no mistake, it is better to dollar cost average than to not invest at all, which is a danger of trying to time the market since even the best investors will miss entry points. Given the OP’s long time horizon (what sounds like 35 or more years), lump sum investing has a much higher probability of producing higher ending wealth.”
Why Dollar Cost Averaging Doesn’t Work
For investors, there are fewer more nerve-wracking moments than deciding how to invest a big cash windfall, the kind that might come from the sale of a business, an inheritance, or a hefty bonus. The instinct among many individual investors is often to gravitate toward dollar-cost averaging, or DCA. Deciding to invest a lump sum into the markets is easily accompanied by a parallel fear: “What if the market crashes tomorrow?” Or next week? Or even next year? The reality is that nobody knows what the market will do tomorrow, next week, or next year.
In their paper, “Dollar-Cost Averaging: Truth and Fiction,” Morningstar’s Maciej Kowara and Paul Kaplan show that historically, DCA has produced lower long-term returns than lump sum investing, or LSI. At the same time, the returns from DCA are more uncertain than the results from LSI – when it comes to meeting an investment goal, this could mean greater risk.
Kowara and Kaplan calculated the results of LSI over all two-, three-, four-, up to 120- month periods and compare them against the final wealth achieved by spreading out the total investment into monthly segments over those periods. They then calculated the percentage of cases in which DCA resulted in more wealth than LSI for each time span. The results: When you look over the average 10-year time frame, nine out of 10 times, an investor who dribbled money into the market would have ended up with less money than if they had simply put all their money into the markets at the beginning.
Of course, long-term averages hide the bumps. What if an investor were handed a $100,000 check in June 2008, just as the global financial crisis was about to break out? Wouldn’t it be better to have done DCA then, and captured the lower prices? Even in 2008, LSI would have been the better choice. Despite the massive haircut taken to the investment in 2008, it isn’t hard to understand the reason for the outperformance of the LSI approach: since hitting bottom in early 2009, the U.S. stock market has been in an uninterrupted bull market ever since. What about investors who got a windfall in June 2009, but – shell-shocked from the financial crisis meltdown – dribbled in their money, instead of putting it to work all at once? They would have been left far behind by the bull market in stocks.
The fundamental problem with DCA is that it is a market-timing strategy. Holding money back and then investing it later only makes sense if investors believe that the prices of the securities they are planning to buy will fall for a while and then eventually rise. As it is unlikely that many investors are making such forecasts, most investors should not be following a DCA strategy.
Buying the Dip Won’t Work Either, Especially in this Environment
Wei Li, global chief investment strategist at BlackRock told Morningstar’s Lauricella that, “in the old environment of The Great Moderation, we were able to enjoy decades-long bull markets in both equities and bonds,” she says. “In this new environment, we shouldn’t expect that. Goldilocks is off the table.”
One of the primary casualties of this new dynamic is the “buy the dip” approach that became pervasive over recent decades. This was fueled by the easy-money central bank policies that dominated major world economies since the 2008 financial crisis. One aspect of this was known in Wall Street jargon as “the Fed put,” a reference to options trading. The thinking was that whenever stock or bond markets collapsed, the Fed would step in to bail out investors.
“You had a situation where liquidity was lifting all boats,” Li says. “As long you had a long enough horizon, you could just keep buying the dips and that would get you to a good place.”
Now, investors will need to consider the macroeconomic backdrop before bottom-fishing. “Today investors need to understand what is driving the correction,” Li says. “The automatic, buy-the-dip reflex will not be working.”
So, What Should Investors Do?
Kaplan points out that dollar cost averaging should not be confused with systematic investing. Systematic investing is putting money into the market on a regular basis as that money becomes available to you. So, for example, if you have a group RRSP at your place of employment, then every month or out of every paycheck, your employer will, on your behalf, take some money out of your paycheck and put that into investments. That isn’t dollar cost averaging. The best thing for investors to do is invest money according to their risk appetite and risk tolerance, as soon as it becomes available.
This article does not constitute financial advice. It is always recommended to conduct one’s own research before buying/selling any security. The author owns the securities mentioned.
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