Dollar cost averaging
By Fly: Malaysia
Investing is somewhat akin to swimming. Some people dive right into the pool, while others prefer to edge gradually into the pool. When you apply these concepts into investing, this begs the question: is it best to invest all your money at once, or is it wiser to invest in smaller amounts over time? To answer this, we decided to break it down for you through exploring the pros and cons with a simple, but relatable story.
Last month, Eddy and Kent attended the Malaysian Youth Finance Seminar organised by FLY Malaysia. They found investing in stock market interesting and decided to kick start their investment journey. After utilizing the knowledge on technical and fundamental analysis gained from the seminar, both their research led to a conclusion that SUNREIT is an excellent long-term investment that would steadily climb in price.
With RM 10,000 on both their hands, it makes sense for them to invest it all immediately right? Logically speaking, people would only invest in something (stocks in this case) that they believe would appreciate in value. In other words, they would only invest in them if they believed that it would yield them higher returns. With this in mind, it makes perfect sense to invest all they have into something that increases over time since it would bring about greater long-term financial gains.
However, they both hold different opinions on whether to invest all their capital in a single transaction in the investment trust or to invest in smaller amounts on a quarterly basis. This resulted in them taking very different approaches in their investment
Let’s take a look at Eddy. Eddy is a risk taker. He decided to invest his capital of RM 10,000 in a single transaction because he believes that SUNREIT is currently trading below its “intrinsic value”. In other words, Eddy’s research suggested that the shares of SUNREIT is on discount!
On the other hand, Kent is a lot more sceptical than Eddy and is reluctant to follow his footsteps. Although his research shows that SUNREIT is an excellent investment, he wasn’t sure about the current value of the stocks. In the end, he decided to invest his RM10,000 via 4 transactions across 1 year, thus translating to RM2,500 each quarter. This allows Kent to make more calculated efforts in his investment.
This type of method is called Dollar Cost Averaging. Essentially, it is a method where you invest proportionally at a fixed amount on regular periods, and depending on the market price of the shares, you would end up buying either less or more of them. Now, this strategy requires a good amount of discipline as you would need to invest monthly. The good news is, you wouldn’t need to wait until the market increases or decreases, as your continuous investment means that you would always see a return.
Back to the Story…
Kent believes that should he invest all his money at once in a particular investment, there is a risk that he would be investing right before a big market downturn. For instance, if you had jumped into an investment just before the market downturn in 2007, you would have ended up losing a lot more money using Eddy’s risky way, as compared to Kent’s more conservative actions.
Let’s break this down even further.
If we agree that SUNREIT is an investment that would steadily grow, we can come to a consensus that the shares you buy TODAY would be the cheapest price as they will ever be. Hence, if you allocate your RM 10,000 over a long period of time, you would be paying a higher price with each consequent purchase.
But do assets continually appreciate?
In reality, no. It is a lot messier and unpredictable contrary to our normal trail of thought. The more volatile or risky an asset is, the greater the probable fluctuations.
Assets do not “continually” appreciate. However, if you base them on their past performance, the average annual return would reflect consistent positive returns. Take a look at the graph below. You can see that from beginning to end, it shows a significant increase in average price; however, you may also notice multiple fluctuations (the parts where it goes up and down) in between those years. We call this short to medium term market volatility.
Dow Jones Industrial Average from 1900- Present (http://stockcharts.com/freecharts/historical/marketindexes.html)
*The Dow Jones Industrial Average (DJIA) is a price-weighted average of 30 significant stocks traded on the New York Stock Exchange (NYSE) and the NASDAQ.
Whether this trend continues in the future is another question. But in the past, a lump sum approach would have been more profitable over long periods, making it a better strategy than DCA.
So why use DCA?
Put simply, we use it to deal with short to medium term market volatility. Take a look at this example from the story.
Price Chart for SUNREIT from 2010 until today.
Price chart from 4th June 2015 to 4th March 2016.
Let’s say Eddy were to purchase stocks on 4th of June at the price of RM1.75 per unit with RM 10,000. The average cost per unit before transaction fees therefore, would be RM 1.75.
However, if we used Kent’s approach to investing, he would invest RM 2,500 a quarter with different prices; therefore, his average cost per unit before transaction fees would be RM 1.58.*
*.(RM1.75 + RM1.47 + RM1.51 + RM1.59)/4 = RM 1.58
By having lower transaction fees, Kent is able to obtain more shares for RM 10,000 when compared to Eddy.
So is DCA the Best Approach?
As illustrated above, DCA may allow for outperformance in shorter time frames.
But even with short and medium term fluctuations, based strictly on long-term results, lump sum investing usually outperforms DCA.
There are 2 reasons for this.
1) As we have seen from the first graph, the general trend shows an increase in the price. Thus, the price you first invested at would have been the best choice to make as compared to buying the stock later on in the years at a higher price.
2) In the grand scheme of the investing time frame, the probability that you will make your lump sum purchase the day (or week or month) before a crash or severe correction is small. If you look back at the DJIA graph, there are relatively few large downward corrections. In other words, the probability of Kent’s worries coming true would be extremely low.
Put simply, the longer the investment time frame, the greater the benefits would be for a lump sum investment compared to a DCA.
Less fees in lump sum investing
Another advantage of lump sum investing would be the transaction costs. Theoretically, this approach should result in less transaction costs when compared to a DCA approach. We will illustrate this using the examples below:
Eddy’s Transaction Fees:
Given gross amount of RM 10,000
*Stamp duty cost for transaction between RM 901 to RM 10000 is RM 10.
In Eddy’s case, total transaction cost is only RM 25.90.
Kent’s Transaction Fees:
Given gross amount of RM 2500 then multiply by 4.
*Stamp duty cost for transaction between RM 2001 to RM 3000 is RM 3.
In Kent’s case, total transaction cost is RM 66.08, which is RM 16.52 multiplied by 4.
At the end, there is no winning investment strategy formula. It all depends on your risk-taking confidence, as well as your investing style. If DCA (though a seemingly underperforming strategy compared to lump sum investing in this article) suits your investing style, why not give it a go? Who knows, you might end up being richer through a safer approach in your investing career.
Fly Malaysia (2017). A Dollar Averaging Tale. Retrieved from https://www.flymalaysia.org/dollar-cost-averaging-tale/