Mike Tyson’s infamous quote that, “everyone has a plan until they get punched in the mouth” is often, and appropriately applied to stock market investors, who claim they’d love to see a market decline that would allow them to buy stocks on the dip.
But often times when that sell-off comes, it’s deeper and steeper than expected. In turn, planned purchases turn to paralysis, or worse, there’s panic into selling existing holdings.
The dramatic decline during this past fall — which took the indices into a bear market and many individual stocks down by 30% or more — seemed to put an end to investors ‘buy the dip’ mentality.
Unfortunately, rather than taking advantage of sell-off, most long-term investors run into the corner due to the disorienting “punch in the mouth” impact that usually accompanies market declines.
One common solution to replacing emotion with discipline is using a dollar cost average (DCA) approach. This is the process of going systemic at present price levels; usually set at percentage terms and equal dollar amounts. This helps one avoid both buying too much on an initial dip, or completely missing the opportunity because one waited for the selling to stop, or tried to find the bottom.
But a recent paper from Nathan Faber of NewFound Research asks whether Should You Dollar Cost Average and concludes DCA results in lower returns than Lump Sum Investing (LCI).
Here are summary bullet points:
- Dollar-cost averaging (DCA) versus lump sum investing (LSI) is often a difficult decision fraught with emotion.
- The historical and theoretical evidence contradicts the notion that DCA leads to better results from a return perspective, and only some measures of risk point to benefits in DCA.
- Rather than holding cash while implementing DCA, employing a risk-managed strategy can lead to better DCA performance even in a muted growth environment.
- Ultimately, the best solution is the one that gets an investor into an appropriate portfolio, encourages them to stay on track for their long term financial goals, and appropriately manages any behavioral consequences along the way.
Dollar-cost averaging (DCA) is the process of investing equal amounts into an asset or a portfolio over a period of time at regular intervals. It is commonly thought of as a way to reduce the risk of investing at the worst possible time and seeing your investment immediately decline in value.
The most familiar form of dollar-cost averaging is regular investment directed toward retirement accounts. A fixed amount is deducted from each paycheck and typically invested within a 401(k) or IRA. When the securities in the account decline in value, more shares are purchased with the cash, and over the long run, the expectation is to invest at a favorable average price.
For this type of dollar-cost averaging, there is not a lot of input on the investor’s part; the cash is invested as it arrives. The process is involuntary once it is initiated.
A slightly different scenario for dollar-cost averaging happens when an investor has a lump sum to invest: the choice is to either invest it at once, or spread the investment over a specified time horizon using DCA.
Lastly, one can take an approach to buy a set dollar or share amount on a pre-determined percentage decline. For example, if the stock pulls back 10% from a six-month high, one should buy another unit if it declines another 10%.
Note, if you are allocating a set dollar amount, you will be buying a greater number of shares on each decline; this is sometimes referred to as a pyramid plan. It can greatly reduce your cost basis, but also leave you with an outsized position. Whichever approach you take, the key is to stick with the process.
About the Author: Steve Smith
Steve has more than 30 years of investment experience with an expertise in options trading. He’s written for TheStreet.com, Minyanville and currently for Option Sensei. Learn more about Steve’s background, along with links to his most recent articles. More...
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