What is Dollar Cost Averaging?
Dollar cost averaging is an investment strategy which involves dividing up the total amount to be invested over regular intervals. The goal of dollar cost averaging is to reduce the impact of volatility on your portfolio. DCA aims to avoid making the mistake of lump sum investing at a time when the market is high and continues to decline for a prolonged period of time. One of the most common time periods DCA advocates refer to is the dot com bubble where the NASDAQ took 13 years to recover from 2000 highs. It’s easy to pick certain time periods out of history like this although the stock market typically experiences all-time highs around 8% of all trading days.
By using DCA investors will lower their cost basis in an investment over time. Let’s take an example, the VUSA S&P 500 costs £59.62 per share at the time of writing. If you invest £500 per month @ £59.62 per share you could purchase eight whole shares. Let’s say the price went up to £65, then you could only purchase seven whole shares. Very simplified I know although the point is valid, you will have more shares at a lower price thus reducing your average cost per share overtime. Unfortunately ETFs (such as the VUSA S&P 500) don’t let you invest in partial shares which would allow you to take advantage of this even further. We mention one of our favourite funds here, the FTSE Global All Cap which is an index fund so your full £500 would be invested each month. It’s not going to make a huge difference but it’s nice to put every penny to work rather than leaving some spare change in your account until the next top up.
What is Lump Sum Investing?
Yep, you’ve guessed it lump sum investing is putting all your money in the market at once. This may sound a bit ‘gung ho’ although statistically speaking it’s not as bad as it sounds. Vanguard completed a study in 2012 which is often cited on the topic and the study found two thirds of the time lump sum investing seems to beat out dollar cost averaging. This probably isn’t that surprising based on the statistic we mentioned earlier about how often the market sees new highs on trading days.
Of course, if you’re invested in bonds as well as stocks say a 60/40 split then there was only a minimal difference between lump sum investing and dollar cost averaging over a 10 year period (around 2.5%). Consider your risk tolerance for lump sum investing if you’re all in on stocks. It’s easy to sit there on a nice green day saying you can tolerate a market crash, can you really though? When everything on the news is doom and gloom and to the moon memes have disappeared from existence will you really be that determined to ‘stay the course’ as Jack Bogle often said.
At the end of the day we can’t predict a market crash and one may or may not be around the corner. As Warren Buffett once said ‘a stock market prediction tells us more about the prognosticator than it does the future’. If you plan on investing for the long haul and you can keep your emotions in check lump sum investing may be a good choice for you.
What is Value Cost Averaging?
VCA works similar to DCA in that you’re putting your money into the market in regular intervals however, the monthly contributions differ and one would invest more when the price of the portfolio falls and less when the price rises.
In essence the main goal is to buy cheap stocks. The results seem to slightly outperform DCA although this comes with the price of added complication and in a way you’re trying to ‘time the market’ which won’t always work out in your favour. If there’s a market crash for example and you put all your money in the market it could continue to fall and you’ve already ran out of money before being able to take advantage of the complete bottom.
You’ll also find once your portfolio has turned into a decent nest egg and compound interest is ticking over the timing of your investments will become even less relevant unless you’re putting a significant amount of money into the market.
It’s really up to yourself in how you want to invest. At the end of the day, each of these three methods are all much better than being completely out of the market. We choose to dollar cost average as it’s easy and well, we don’t have a huge lump sum of cash sitting in the bank account unfortunately. VCA might be a good alternative approach to consider if you feel like you can squeeze a slightly better return out of your portfolio although in our opinion you would probably benefit more from finding ways to increase the amount you can invest each month. For a more in depth take on value averaging you can find Michael Edleson’s book here.
The views expressed in this post are the authors and should not be construed as financial advice
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