Dollar-Cost Averaging vs Market Timing July 19, 2024

Many want to grow their wealth but few know how. We’ve all heard of the recent trends that have minted many millionaires – Crypto, NVDA, GME and Cocoa futures, for instance. In hindsight, if only we had also been on that rocket to the moon, we could have made a fortune for ourselves. However, it’s also well-known that professionals such as fund managers seldom outperform the benchmark, let alone retail investors who fail frequently.

Should retail investors, therefore, consider a passive strategy that generates reasonable returns without having to spend as much time as a full time hedge fund analyst? In this article, we will explore how a seemingly boring strategy compares to market timing.

Setting the Stage

In our study, we take on the persona of an average retail investor with an annual investment budget of S$10,000. This investor either uses a boring Dollar Cost Averaging (DCA) methodology or attempts to time the market.

The chosen instrument for this study is SPY, an ETF that tracks the S&P 500 index. It is selected for its liquidity, extensive historical data, and broad coverage of the US stock market. Whether or not SPY is the best instrument for investment is the topic for another study.

In the DCA scenario, the investor consistently invests an equal portion (S$833) at the start of each month into SPY. Next, to study the effects of market timing, we assume two extreme cases in market timing, (i) always buying at the year’s highest price and (ii) always buying at the year’s lowest price. each with an annual budget of S$10,000.

The study analyses 10 years of SPY data from 1 July 2014 to 30 June 2024 and is split into 10 years for determining the entry points for the market timing scenarios.

Results

Intuitively, the chart above demonstrates that DCA is able to provide returns bounded between the two extreme scenarios of market timing, but with much lower effort. Furthermore, this raises an important consideration: are we confident of our ability to consistently outperform the market, justifying the extra effort over a simpler strategy, or is our time better spent elsewhere?

Now, let’s look at some key statistics:

The “Compounded Return” has been calculated as the annualised total return on all money invested i.e. on S$100,000. This is a simplistic heuristic to compare the strategies and does not reflect the average return of each dollar invested (which will be higher since money invested earlier would’ve accrued a higher return).

While SPY is shown here for reference, it should not be used for direct comparison as the investor in our study does not have S$100,000 to invest on day 1. Nevertheless, DCA provided a respectable return of 7.67% which is quite considerable on a total return basis.

To put it into perspective, the S$833 invested every month grew to almost S$210,000 in 10 years.

Points to note

Is Dollar Cost Averaging (DCA) the holy grail? Perhaps not. Let’s delve into some critical drawbacks of this study to gain a deeper understanding.

DCA Works Well In Uptrends

One of the key points to note in the above study is that we chose SPY, which has historically been on an uptrend. In short, DCA works well only if the chosen market trends up. For example, if you had started to DCA since 2021, you’d find that returns are subpar for the first two years.

However, it is comforting to note that SPY is generally in an uptrend over the long term as it’s a tracker of the top businesses in the US, which are likely to grow as long as the US continues to be a major global power.

DCA and Cash Flow

DCA offers reasonable long-term returns with minimal effort, providing a viable option for managing cash flow if you lack a clear investment strategy.

However, what if you already have S$100,000 sitting idle in your bank account? DCA doesn’t provide guidance on how to invest a lump sum, which might be better suited to a different investment strategy such as asset allocation—a topic for further exploration.

Dependency on the Underlying Asset

Another limitation relates to the selection of investments. While DCA outlines an approach to market entry, it does not advise on which assets are the best to invest in. SPY has historically been doing well but the future is always uncertain. An alternative approach could be to diversify by selecting a mix of sector-specific or country-specific ETFs.

Conclusion

If you are an investor who is confident that you have an edge or a good read on the market, the method of timing the market could work well for you. However for the vast majority, DCA offers a straightforward entry into long-term market investment.

Even for the sophisticated and aggressive investor, DCA with a basket of ETFs can still serve as a foundational strategy for one’s cashflow on top of layering asset allocation strategies to optimise for better returns and minimise draw downs.

Eventually, it all boils down to one’s needs, goals and investment horizon but the key takeaway from this is to take action.

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