Is Dollar Cost Averaging The Best Investment Strategy?
I was told recently that the easiest way to invest is to DCA (dollar cost average) into a world index fund. And yes, it is the EASIEST way to invest. However, is it the best investment strategy?
What is Dollar Cost Averaging?
Dollar cost averaging is merely a strategy of buying regularly. This allows you to average out the cost of purchases, since when markets do badly, you are essentially buying it cheap. Dollar cost averaging, especially into a world index fund, is probably a cheap and easy way. But as with any strategy, there is a catch.
The Untold Catch of Dollar Cost Averaging
In investing, downside risks outweigh upside capture. A 50% downturn requires a 100% move upwards to recover. That is why protecting your assets is important. If your portfolio started out with $1,000 and met a 50% downturn, it will be worth $500. To get back to $1,000 would mean a 100% growth (the reverse is also true).
To complicate matters, if you did DCA your invested amount actually increases over time; meaning market movements at the tail end of your investment horizon actually has a larger impact on your portfolio. A market crash at the tail end will have a much larger effect on your portfolio than if it happened at the start of your investment journey. This doesn’t apply to a lump sum investment though, but it is extremely relevant in a dollar cost averaging strategy.
To see why, if you invested $1,200 a year over 30 years, the amount invested would increase
over the years. By year 30, you’d invested $36,000. If a crash happens after 5 years, only $5,000 invested would face that same loss in value.
If however, a crash happens at the end of year 30, the entire $36,000 that you invested would face the same dip.
And though it is true that the market evens out losses and gains over time, and generally, recovery does happen, the critical element needed is time. At the end of your investment horizon, you have sadly run out of time. Time is your biggest ally, and concurrently it is also your biggest challenge in life.
The Better Strategy - Portfolio Allocation
So how do we make the best out of this double-edged sword? I propose that rather than simply doing dollar cost averaging, it is crucial to look at portfolio allocation in response to your leftover available time. Everyone knows that this means you use less risky assets as you approach event X. But this is tricky from an emotional perspective. It is tricky because the lower the risk, the lower the return. And as we approach the horizon, it is hard to switch out into lower yielding but safer instruments, especially as the market is booming.
The trick is to remember that the key idea is that we are not aiming for the highest possible returns; that is an important point. The critical point is to remember to ACTUALLY get the returns. There is no point in saying your investments had a year of superb returns, only to have it all wiped out due to poor conditions the months running up to the end.
A good advisor understands this. And a good advisor will be able to help you navigate and fight your initial instinct to keep investing, to ensure that when the time comes, you will have the funds necessary to live your life.