DCA: Not always a good idea

11/26/2021 | 09:51am

Often presented as a miracle solutions to new investors, DCA combines simplicity, performance and risk minimization. But like any methodology, there are some limitations. DCA is a simple investment method, but there are some rules, often ignored, that can prevent some disasters. In this article, we'll look at the big mistakes to avoid when opting for this so-called passive investment strategy. But before venturing into the drawbacks, let's quickly review this investment method.

Dollar Cost Averaging (DCA) is a long-term investment strategy that aims to protect against the volatility of a financial asset. Opting for this investment strategy means investing a certain predefined amount at regular intervals for a very long period of time (at least more than a year). In other words, identical purchases must take place regardless of the price of the asset. The only rule is to respect a certain time frame set up in advance related to the placing of orders (weekly, monthly, quarterly, etc.). Although it seems simple on the surface, it can be complicated to respect these rules when the market seems to be over or under valued. That's why this strategy is best suited to passive investors who aren't interested in valuations. But as a graph is worth a thousand words, let's look at the example below

Source: MarkScreener


Dollar cost averaging has three major advantages. First, by investing mechanically, you eliminate the emotional component of your decision making. You will continue to buy, no matter how much the price fluctuates. Frequently, when stocks go down, people get scared and sell. Then, when the market rises, they miss out on potential gains. In theory, no matter how high the market goes, you should buy. This means two things. When the price goes down, we buy more stocks and less when the price goes up. So, it's a good idea to average down your purchase price (PRU). Conversely, when the stock market is rising, some investors may be tempted to rush in and buy at the top (FOMO). By investing your money all at once, the risk of investing just before a sharp market decline is much greater. This can mean that you have to wait many years to get back to pre-crash levels. By adopting a programmed investment strategy, you avoid the risk of bad timing. It is simply impossible to determine the high or low point of a market. On the other hand, although the DCA avoids investing at the top, it also limits the probability of investing at the bottom. Thus, the probabilities of performance at both ends - i.e. very good and very poor - are reduced. See attached chart.


Source: MarketScreener

But the problem with DCA is that this strategy is commonly misused, or at least on the wrong products. The DCA is rightly presented as an "anti-headline" strategy. No matter how high the market is, we buy. So what could be the catch?

Apart from the fact that we are relying on the idea that markets will go up forever, an assumption I am forced to agree with, a far more important concern exists. This strategy is viable if and only if we buy stock indices (ETFs: Nasdaq, KWEB, MSCI China...). Why? Because an index never dies unlike the stocks that make it up. Indices do what any good investor should do. That is, overweight the stocks that are going up and underweight the stocks that are going down (or at least not growing much). When a stock declines too much or goes bankrupt, it is ejected from the index and directly replaced.

Let's take the example of the Dow Jones, the historical index of the USA. Between 1978 and today, only 3 stocks have remained in the index (Coca-Cola, IBM and P&G). The others have been replaced and are now probably unknown to you (Nash Motors, Westinghouse Electric, National Steel...). While these companies have disappeared or been forgotten, the DJA has risen by almost 4334% since 1978.

Many investors opt for a DCA strategy when investing in a stock or cryptocurrency. However, we can only opt for this management method if we buy an index. The reason is simple, a stock can go down until it disappears. Theoretically, an index cannot. Let's take a commonly used example to illustrate the limitations of DCA: Bitcoin.

A small disclaimer is in order. I don't want to be bearish on this asset, quite the contrary, however the example of bitcoin is surely the most telling. So let's put aside our convictions on this asset and just try to understand the message. Otherwise replace the crypto-currency example with a stock of some sort. Anyway, back to the main topic.

First, a non-trivial backtesting error exists when we refer to a DCA approach on bitcoin. Since all market drops have been traced, many conclude that the next ones will be too. The famous "Buy The Dip." But there is no assurance that the price of bitcoin will continue to rise indefinitely (unlike an index). In other words, while the DCA allows us to smooth out our PRU and detach ourselves from volatility, it can also lead us to regularly invest in a losing investment.

Understand that we may like a technology, a business but not a particular stock if we don't get serious about it. If I am a bit more careless about bitcoin due to its great complexity to analyze and understand it, and the impossibility to define a consistent price, on the other hand I am much less flexible for stocks. Let's take some very telling examples to better understand. New entrants can disrupt a market (Tesla vs. automotive industry), challengers can overtake leaders (Google vs. Yahoo), promising companies can never really explode (Criteo, StoneCo) and some can even go out of business or fail (Enron, Wirecard). Theoretically, DCA could work on a stock, if and only if we consider that companies always keep the same financial shape, grow infinitely and never die (like a stock index). So while DCA doesn't really come to mind for a stock, it is nevertheless commonplace when we talk about crypto-currencies.

But be careful not to misinterpret what I'm saying. Reinforcing a position is not forbidden, quite the contrary. We can even strengthen a position monthly, quarterly or otherwise. Anyone who is paid monthly can be led to strengthen his position on bitcoin once a month, which it finally corresponds to his monthly savings capacity. Likewise, entering a position in installments is not to be banned either. It is a form of time diversification. Some people argue against this diversification by justifying that if you see a stock as a great opportunity, prefer to enter in one go, as a short-term price drop should not normally challenge your long-term thinking. This is why I'm so flexible with bitcoin, but I think it's worth being aware of it.

If you just want to minimize your risk, prefer diversification to DCA.

"An index never dies unlike the stocks that make it up"


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