What is the Dollar Cost Average approach
The Dollar Cost Average approach (DCA) is when you invest in regular intervals in the stock market. The idea is to put repeatedly the same amount of money into your security of choice. Often savings plans are designed that way.
If you buy an ETF with that approach you buy with the same amount of money less shares when the prices are up and more when the market is down.
Investing CHF 500.00 each month in the same ETF while one share costs CHF 100.00 will get you 5 shares. The next month one share costs CHF 500.00 then you get 1 share.
The result is that your Average share price is always below the all time high and above the all time low of your ETF during your investment period.
The Dollar Cost Average Myth:
In theory the DCA effect seems a no brainer. Reality however can paint a different picture. Here are four examples that you should consider when choosing the DCA approach:
I. The market should decline for a long period
The goal of investing in the financial markets is to increase your portfolio over time. Your invested money should work for you and grow. Otherwise investing would make no sense in the traditional way.
With that assumption and what history shows us you have to question yourself why you are investing regularly and not all at once.
Therefore the DCA approach makes only sense if the markets decline for a long period. If the markets tend to go up – what was mostly the case in the past – investing in intervals will be suboptimal compared to the lump sum approach.
II. With a long investment horizon DCA looses its effect
What is often not considered is a long investment horizon combined with a growing portfolio. In that scenario your monthly contribution will have a smaller impact the further down the road you go. Let’s say you keep investing CHF 500.00 every month. When your portfolio reaches CHF 20’000.00 the monthly contribution will have almost no significance anymore to your average share price.
III. Transaction costs
Transaction costs is another factor that you have to consider over time. Many setups are not completely free and investing generates fees. While transaction costs might seem not significant at first, in the long run they can have an impact. Don’t neglect the costs on each trade you are doing and think how this will affect your portfolio in the next 5 or 10 years, even if it is only a small amount each month.
IV. What about a crash
What if you invest in the all time high of the markets? Share prices are at record highs and you are worried about entering the market now? This is a common argument against investing that people say for the last couple of years.
Looking at the MSCI world for the last decades you get a different view.
The chances of you investing at the worst possible moment are very low. Even if you went all in in 2000, 2008 or March 2020, by now your portfolio would have more than recovered. Assuming you are well diversified of course and not putting all your money in one stock.
Considering the mentioned points above investing long term should ease your fears of a crash. Even big crashes like 2008 recovered after three years. Again the chance of you going all in right before that event is unlikely.
Lumps sum vs investing regularly
There are no good reasons to postpone your investment when you want to invest long term in a well diversified portfolio.
Time in the market beats timing the market. Participating trumps waiting for the right moment to jump in.
Obviously don’t invest money that you might require on a short term basis. Also don’t invest with the intention to get rich quick, that is speculation and has nothing to do with investing. Investing is rather boring, takes a long time and you need patience.
Why investing monthly (savings plan) can make sense
Investing regularly still has a place and can make sense in certain situations. My own investment rules also follow this approach.
- You don’t care about the points mentioned above and just feel uneasy with the lump sum approach. You should not loose any sleep over an investment decision, in that case follow your gut feeling and split your investments.
- You want to invest a part of your monthly salary or you have a savings plan for your kid where you only can contribute small portions at a time. Then this is the only way to grow your portfolio over time and makes absolute sense.
- You create your own automated savings plan with fix rules so that you don’t have to do any market timing. This approach will save you time and make you feel better.
- You plan to enter the crypto market which is volatile and unpredictable.
In the end go for the approach that you feel most comfortable with. Also keep in mind that history does not say anything about the future. No one knows what tomorrow has in store for us. If you hear advice from people predicting the future don’t pay much attention to it.
No investor can accurately and consistently predict the future. There are an infinite number of variables that can affect company performance, the economy and stock prices. Seeking to second-guess them, and how they will interact with one another in a fluid economic environment, may prove to be an impossible task that does not lead to an efficient allocation of your capital. – Warren Buffet
If anybody has a way to see the future this person would not share the advice and probably be on top of Forbes list of the most wealthy people in the world.