The Big Drop – Investments in Unit Trusts – When Should You Consider Using Dollar Cost Averaging?
My left brain talks to my right brain:
On 3 February 2020 morning, as I took the lift up 13 floors of Capital Towers to office, the monitor mounted on the lift with Channel NewsAsia broadcast had the following newstream at the bottom that reads “China stocks nosedive 9%”. I witnessed a discussion in the lift which went something like:
Right brain: Oh dear, China stocks tank 9% in just one morning. This is scary!
Left brain: This is not unexpected. Anyway, the 9% drop is only because the Chinese stock market has been closed for a prolonged period due to the virus.
Right brain: This is terrible. Maybe time to sell all my funds now. It might drop further! Doomsday is here!
Left brain: We have seen this happen before. Anyway, I will be able to invest some on the cheap.
Right brain: I am never going to touch stocks and funds again. This is too volatile for me. I have a weak heart. It is time to cut losses and put my money in fixed deposit accounts.
Left brain: Thankfully I still have sufficient ammunition. Anyway, I am holding a long-term view with my investing rhythm. Volatility is part and parcel of financial markets. It will be good to stay invested and increase holdings as I have been doing. I will profit in the longer term.
Recent market meltdown; fear rules! Is there a way to mitigate volatility?
Since that fateful 30 seconds in the elevator, markets have tumbled on a much larger scale, with equities far beyond China reflecting the economic uncertainties brought about by COVID-19. The Dow Jones index in the US for example, went from 29348 points on February 19, to only 18591 points on March 23. That is a massive 36% drop over just 23 trading days! That, is what a complete meltdown looks like. Markets have come off their lows but there is uncertainty over the direction in the short and medium terms.
Many, upon such turbulence, will be tempted to cut losses and head for the exit. There is a fear that shivers down the spine. It is all doom and gloom. They see only the dark clouds.
Have we not been through this before? Remember the dot com bubble and subsequent burst? The aftermath of September 11? The global financial crisis, brought about by sub-prime issues? And before then, the Asian financial crisis, which brought currencies, financial markets and even governments down to their knees? Markets eventually recovered after a rough patch and found an even higher gear.
Volatility in the financial markets is what many people fear and as such, they stay away completely but at some cost. Financial markets, while turbulent at times, deliver returns that are far superior to safe haven instruments like fixed deposit and savings accounts. The key is how we are able to ride the cycles in a safer manner, and participate in long-term gains.
Dollar Cost Averaging – What is it? How does it work?
How then, do we counter such short-term focused emotionally-driven reaction? One option is to be strategic with your investing rather than being short-term tactical, by investing using a strategy called ‘Dollar Cost Averaging’. According to Wikipedia, Dollar cost averaging (DCA) is an investment strategy that aims to reduce the impact of volatility on large purchases of financial assets such as equities. By dividing the total sum to be invested in the market (e.g. $100,000) into equal amounts put into the market at regular intervals (e.g. $1,000 per week over 100 weeks), DCA seeks to reduce the risk of incurring a substantial loss resulting from investing the entire lump sum just before a fall in the market.
Dollar cost averaging may not always be the most profitable way to invest a large sum, but it is able to minimize your investment risk. The technique is said to work in markets undergoing temporary declines because it exposes only part of the total sum to the decline. The technique is so called because of its potential for reducing the average cost of shares bought.
As the number of shares that can be bought for a fixed amount of money varies inversely with their price, DCA effectively leads to more shares being purchased when their price is low and fewer when they are expensive. As a result, DCA can lower the total average cost per share of the investment, giving the investor a lower overall cost for the shares purchased over time.
Evaluation: Test 1: Period 2008 – 2020
We look at the most followed market of them all – The US market. Dow Jones, the main barometer of the stock market, stood at 12,654 points on April 1, 2008. Exactly 12 years later, the index was 20,944, representing an increase of almost 1.6 times in the preceding 12-year period.
I model them using two investment methods, with the same amount. While DCA is usually done on a monthly or quarterly basis, for the purpose of capturing trend and avoiding the clouding of the analysis with too much data, I will assume it is done only once a year here. Also, let’s assume we invest the entire sum of money in a fund that derives its value, and price movement, entirely from the Dow Jones.
a. Portfolio 1: Dollar cost averaging – $10,000 a year, beginning on 1 April 2008, and the same amount on 1 April every subsequent year with the last investment in April 2019
b. Portfolio 2: Lump sum – $120,000 lump sum, on 1 April 2008
Click image above to enlarge
Key observations:
1. The lump sum investment yields a better return after 12 years. Portfolio 2 is valued at $198,605 12 years after the investment. Portfolio 1 however, has a lower value of $173,031 on the same date.
2. Portfolio 2 experienced more volatility. There is a horrific drop in value in April 2009 (the aftermath of the housing/financial crisis). The $120,000 invested a year ago became only $73,602. That’s a 39% drop in just 12 months! While Portfolio 2 gained back some ground by April 2010, the value was still below water.
3. Portfolio 1 on the other hand, enjoyed a 9% gain by 1 April 2010.
4. Looking at the 12-year time frame, Portfolio 1’s gain/loss fluctuated between -19% and +81% (and value wise, -$3,866 and +$96,942). For Portfolio 2, the gain/loss during the period ranged between -39% and +108%. Value wise, the gain/loss range was -$46,398 and +$129,006.
5. In percentage terms, Portfolio 1 actually delivered more than Portfolio 2 during the first 7 years. In the five years which preceded 2020, Portfolio 2 finally made up ground over Portfolio 1.
Conclusion:
1. Portfolio 1, which is constructed on a DCA basis, is slightly weaker than Portfolio 2 (lump sum investment) in gains over the longer term (after 7 years). However, Portfolio 1 helps the investor participate in long-term gains while providing some cover against strong headwinds. Portfolio 1 is much easier on the heart!
Evaluation: Test 2: Period 2014 – 2020
Observers here might argue that the time period here covers the global financial crisis and hence we see high volatility. Hence, I am constructing here, the same analysis but a timeframe of 6 years, with Day 1 being 1 April, 2014.
Click above image to enlarge
Key observations:
1. As with the previous exhibit, Portfolio 2, which is a lump-sum investment, does better in terms of returns. The gain as of 1 April 2020 is $76,008, against $63,248 for Portfolio 1.
2. Even without the big dip induced by the global financial crisis, Portfolio 1’s gain/loss range is smaller, from 3% to +32%.
Conclusion
Regardless of timeframe modelled, the picture remains that DCA, while not completely eliminating the impact from market volatility, provides investors with a smoother ride even as fortunes swing. This enables investors to breathe easier, and greatly reduces decisions driven by emotions, which could be very costly.
Imagine what must be going through the investor’s mind in April 2009, if he had Portfolio 2, on a lump-sum investment in 2008? His right brain will be making a big push to have him exit the market altogether, and take a big loss. He would be much more likely to make the wrong decision if he were a Portfolio 2 investor.
While a Portfolio 1 DCA investor will generate lower returns over both the 6 and 12-year periods, he can actually park his funds in low-risk instruments (like short-term bond or cash funds), and release them every year for his DCA mechanism. The returns from those low-risk instruments can help narrow the gap against the returns from Portfolio 2.
A case can also be made for using DCA for someone who has not saved a lot of money. He can invest gradually, thereby participating in the financial markets on a DCA basis, rather than having to take time to accumulate large amount of savings before a significant lump-sum investment.
Now that we understand DCA can lower the portfolio volatility, we are left with the task of evaluating where and what to invest in, which should be dictated by our risk profile. Some types of funds lend themselves better to the DCA method than others. When we utilise DCA and construct a portfolio aligned to the risk profile, we invest within our comfort zone, and we are flattening out volatility.
Therefore, I have created this Investment Risk Profiling Tool for DCA Suitability to help you understand your risk profile, and in turn, which categories of funds are suitable for you as an investor. Click HERE to download the Investment Risk Profiling Tool for DCA Suitability.
Investors often try to time the market, and place big bets (either upon entry or exit), and invariably, that depends on good judgment, a huge dose of luck and emotion. By investing on a DCA basis, we reduce the significance of these factors. We invest like a robot. It is a fallacy that we can buy at the lowest point and sell at the highest, lump-sum. We will not know when or where they are.
For those with a very strong stomach for risk and volatility, they can invest lump-sum and potentially reap higher gains over the long term. However, for most others, the DCA method provides solace. DCA enables us to buy low, sell high. We only need to believe that markets eventually trend up and recover from blips. With the current malaise we now face, and the uncertainty lording over financial markets, DCA is now more relevant than ever.
And, for the record, my left brain won that discussion in the lift.
Article by Leon Loh
Email: leon.loh@gen.com.sg
The writer is a financial adviser representative representing GEN Financial Advisory Pte Ltd
