I wrote an article comparing DCA (Dollar Cost Averaging) against market timing a few weeks ago. In that particular article, the scenarios painted are based on the assumption that a lump sum wasn't present at the beginning of the investing period and hence periodic purchases of stocks are necessary.
In this article, I like to explore a bit deeper on DCA in a slightly different context. This time round, I'm going to assume that there is a lump sum available for investing at the very beginning and let's see what's a better approach to take in this case- DCA or Lump Sum Investing?
Much has been discussed about this topic by various bloggers, with different groups of people having various different interpretations on this topic. However, I notice that there are many different kinds of scenarios where this topic can be applicable on. Hence, I would like to propose a mental framework here to aid readers in making the best decision between DCA and Lump Sum Investing through a series of questions you could use to ask yourself.
First and foremost, we have to understand that this dilemma arises because you have a sum of money which you would like to invest. The only question you have is how and when do you invest this sum of money to have a better chance of getting better returns. If you do not already have this sum of money, this dilemma will not be present and the framework discussed in the rest of this article will not be applicable to you.
Ready?
Now, ask yourself this first question.
1) How long do I intend my DCA period to be if I were to choose to do DCA?
This is particularly important. If you are looking at a DCA period beyond twelve months, chances are you should go ahead with Lump Sum Investing. I suppose you will ask why.
The stock market is built on a capitalism concept which means that economic growth is the centrepiece of the society. Companies strive for growth, increase their profitability and drive up their valuations. All these are reflected in the stock market and hence the market should always be on an uptrend from a long term perspective. Do note that I mention the market, and not individual companies or stocks here. While market always recover, individual companies might not and this upward trend do not necessarily apply to them.
If the market has been on a uptrend perspective, the likelihood of you losing on potential gains on your full invested sum increases quickly as the DCA period goes beyond a year. That's not forgetting any potential dividend gains which you could already get had you already been fully invested. An interesting article here showcases the author's attempt to deep dive into finding the best DCA period to beat Lump Sum Investing. Not surprisingly, it was advised that DCA should not be done for any duration more than twelve months. This advice is also backed up by Vanguard in their research.
Hence, you are better off doing lump sum investing if you are looking at a DCA period of more than 12 months.
Now, let's move on to the second question which you have to ask yourself.
2) If I were to invest immediately now with a DCA period of less than 12 months, do I stand a better chance of getting better returns with DCA or Lump Sum Investing?
Drawing references from the Vanguard Research, extensive research on markets in the United States, the United Kingdom and Australia have shown that an immediate lump sum investment beats DCA method of investing monthly in a rolling 12 months period about two-thirds of the time.
This shows that statically, you are going to have a better chance of getting better returns with Lump Sum Investing instead.
But wait, there is a caveat though..
The same research has also shown that the DCA outperforms Lump Sum Investing during bear markets. While you are more likely to have less gains with DCA as compared to Lump Sum Investing during bull markets, you are also more likely to have less losses with DCA as compared to Lump Sum Investing during bear markets. Hence, lump sum investing do not outrightly outperform DCA in all market conditions.
Hence.. here comes the final question.
3) Could I do anything to increase my chances if I know that Lump Sum Investing tends to do less well as compared to DCA during bear markets?
There are some technical indicators which you could potentially rely on to provide you some guidance with the general market directions/conditions.
Eg, the use of Simple Moving Averages. When the SMA(Simple Moving Average) 50 crosses below the SMA 200, it signifies a "death cross" in technical terms which often points towards a long term downtrend for the market.
Using STI ETF as an example, I attempt to see if such technical indicator allows me to identify bearish markets successfully. Turn out I'm not wrong.
Those circled are periods of time when the SMA 50 crosses below SMA 200. They also signify prolonged periods of downtrend (which is when DCA tends to do better than Lump Sum Investing).
Hence, you might want to be extra careful when such bearish technical indicator is present as this could mean that your chances of outperforming with Lump Sum Investing will drop substantially as compared to using DCA.
This is when you might want to consider switching your investing strategy to DCA instead. And more importantly, it's also critical that you stick to your DCA method diligently during this period to avoid having your emotions come in play. Remember, the key is to be systematic for DCA to be effective.
If the market enters into a bullish territory (SMA 50 crosses above the SMA 200) before you complete your DCA purchases, you might then consider changing from DCA to Lump Sum Investing again to better your chances of success of getting better returns.
Of course, relying on technical indicators are definitely not fool proof. In fact, there might still be occasions when you end up doing a Lump Sum Investing (when the technical indicator is bullish) right before a crash. However, such situations don't happen too often. In most cases, these technical indicators should give you better chances in making the correct decision between Lump Sum Investing or DCA.
Finally, here are your few key takeaways after you complete the mental framework.
1) Given a lump sum for investing now, it is best statically to either invest it right away or complete the DCA purchases within a 12 months period.
2) In general, Lump Sum Investing tends to beat DCA two-thirds of the time. However, DCA tends to do better than Lump Sum Investing during bear markets.
3) With the use of some technical indicators, switching from Lump Sum Investing to DCA (and vice versa) could be attempted to better your chances of success of getting better returns.
Hope these aid you in your decision to deploy your war chest!
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