5 disadvantages of using dollar-cost averaging into a downward market
For those following the stock markets, we have already seen Covid-19 severely impact global stock prices. Since the start of 2020, the S&P 500 in the US is down 28.7 per cent, Hong Kong's Hang Seng Index (HSI) has plunged 21.6 per cent, while locally, the Straits Times Index (STI) has dived 25.2 per cent.
Utilising dollar cost averaging to overcome our limitations
For ordinary investors like us, we are unable to correctly time the market and do not have insights into the best time to invest in any particular stock. However, in many research materials, even the professionals have been found to be unable to do so on a regular basis.
Another limitation most of us have is that we don't have a large sum of money to invest in the first place. We also lack the expertise to take emotions out of investing, and may be prone to make sub-optimal decisions to buy or sell based on greed and fear, especially when navigating a volatile market.
One strategy beginner investors can utilise is dollar-cost averaging (DCA). When we dollar-cost average into the markets, we consistently invest a fixed sum of money into the stock market over a period of time.
We continue to do so regardless of whether prices are going up or down - buying less stocks when prices are higher and more when prices go down. Mathematically, this smoothens out the price that we pay for the stock, allowing us to pay a price that is closer to its average price over a long-term.
This eliminates the element of market timing or having expertise in buying particular stocks just before they experience an upswing in prices.
Doing this consistently also enables us invest a smaller sum on a regular basis and be more disciplined in our approach rather than rely on emotions to form our investing decisions.
While this can sound like a sure-win strategy, there are disadvantages we need to be aware of, especially during a downturn.
#1 When you dollar-cost average, you dollar-cost average (no matter what)
When we apply a dollar-cost averaging strategy, we have to be consistent about it for it to work. During periods when the market trends upwards, it is easy to continue investing, seeing that we may be better off each month.
During market downturns, we need to continue having the same discipline to invest regularly. Majority of the investments we can dollar-cost average into allows us to stop making our investments whenever we want to stop.
While this is a key advantage, compared to investment properties or investment-linked policies, we should not turn it into a disadvantage.
As Covid-19 has wrecked havoc on the stock market, it can be easy to say that we will stop investing for now, and resume our dollar-cost averaging strategy when markets go lower or start to improve.
However, that is exactly what timing the market means - which is something we were trying to avoid in the first place by embarking on a dollar-cost averaging strategy.
#2 Dollar cost averaging into bad investments will not help you
Don't try to catch a falling knife.
This adage is commonly used in the investing world to suggest that we should not invest in a stock simply because its price is falling. If we keep dollar-cost averaging into a poor investment, akin to catching a falling knife, doing so will very likely leave us in the red.
This leads us into the next point - we need to dollar-cost average into investments that are not only good, but that also makes sense for the dollar-cost averaging strategy.
#3 You should dollar cost average into investments that make sense for the strategy
We may not be able to employ a dollar-cost averaging strategy to all investments. For some investments, it will simply be too costly to make sense, and for other investments, the strategy of being long-term may not be appropriate.
When we dollar-cost average, we need to do so in investments that can stand the test of time and be cost-effective.
If we are not savvy or confident enough to pick out stocks for this purpose, we can simply choose to dollar-cost average into country indexes, such as the Straits Times Index in Singapore, the S&P500 in the US, the Hang Seng Index (HSI) in Hong Kong and many more.
We can typically invest in country and other indexes via one of the four local brokerages that allow for Regular Shares Savings (RSS) plans. We can also utilise robo-advisor services such as StashAway, Syfe, or Endowus, that have built their portfolios to cater towards the long-term and regular investing (or dollar-cost averaging).
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#4 A substantial portion of your money may sit idle while your dollar-cost average
If we have a large lump sum to invest, but choose to employ a dollar-cost averaging strategy - we will have a large portion of our funds sitting idle. These funds are losing their purchasing power due to the effects of inflation or are being held back from growing in the markets.
In general, stock markets tend to trend upwards in the long-term. That's why we're investing in the first place. If we had a lump sum to invest, putting that money to work, as early as we are able to can potentially lead to better outcomes.
If we are investing into income generating stocks, such as blue chips or REITs with regular dividends, we can be losing out on income while trying to dollar-cost average into our position.
While investing lump sum as early as possible can potentially lead to better outcomes, it can be a risky strategy.
Even if we do not want to invest the lump sum, and want to apply the dollar-cost averaging strategy, we need to think about how to earn a (lower) return on the rest of our funds.
This can be through a high-interest rate savings account, the Singapore Savings Bonds (SSBs), or other types of safe and liquid investments.
#5 Able to generate much higher returns if you can accurately spot investment themes
If we were able to ride the market rise from the doldrums of the 2008 Global Financial Crisis (GFC), we would still be sitting on profits today, even after the stock market nosedive on the back of Covid-19.
Better yet, we could have sold everything in Jan 2020, we would be in an even better shape.
Getting in as early as we can, with as much as we can, in the right investments definitely works. Similarly, getting out as early as we can also works.
Being able to spot stellar stocks like Apple, Alphabet, Netflix, Amazon, or any of the other stellar stocks that we can mention, the current market crash is just a small hiccup (so far) on the back of the last decade of gains.
While this is a disadvantage of the dollar-cost averaging strategy, we need to understand ourselves to decide if we should or should not go ahead with it. This goes back to the start of the article:
- Are we able to correctly time the market on a consistent basis over a very long period of time?
- Do we have the expertise or access to information that will give us insights into when to buy into certain stocks?
- Even if we can spot the right time in the market cycle to invest or have insights on when to invest in a stock, are we able to keep our emotions in check when volatility strikes?
This article was first published in Dollars and Sense.