What we think we know can be deceptive.
For example, try to remember the exact contents of one of your bookshelves, or draw a picture of a bicycle and include the details: the seat, the chain, and the pedals. Unless you’ve practiced or have good reason to remember, these seemingly simple requests can be anything but easy.
So it is understandable if you don’t grasp the range of touch points behind dollar-cost averaging (DCA) in investing.
DCA is arguably among the most frequently recommended investment strategies, so the recent, unprecedented demand for India’s version of the DCA — the Systematic Investment Plan (SIP) — is noteworthy. Retail investors in India who are using the SIP method have comfortably overtaken foreign institutional investors (FII) as marginal buyers in the stock market. This is an important trend given India’s low retail equity ownership. While India’s FII inflows could pick up again, sustained retail participation in the country’s listed space may lead to a superior and less volatile source of liquidity.
Why has the averaging approach attracted retail engagement? DCA involves buying a predetermined dollar amount of equity shares or investment units at regular intervals. The strategy relies on a behaviorally simple construct to invest. Instead of asking an investment unit buyer to invest a lump sum in a targeted portfolio allocation, DCA offers a basic alternative: a “dollar amount at a time.”
The process of investing a smaller fixed amount at regular intervals over a longer period, as opposed a lump sum all at once, is appealing because it creates an illusion of control — the appearance of discipline — and is a seemingly less-risky choice. Kenneth French has a word of caution, however: DCA may provide investors with a better investment experience, but not a better investment outcome.
What are the biggest drawbacks of the DCA approach? Take the hypothetical case of a continuously upward-trending asset price. With every upward asset price movement, a DCA investor buys the asset at sequentially higher prices. The DCA investor fares better than a lump-sum investor only when buying at lower price levels than the initial cost. Furthermore, a delayed-targeted portfolio allocation, which is inherent in the DCA approach, can lead to subpar performance. Ironically, a DCA investor is better off only if the invested asset price decreases over time.
DCA and other investing frameworks, such as the passive approach of robo-advisers, are behaviorally easy investment entry points. They extend market reach and help democratize the marketplace. But the outcomes of these approaches may not be the best. Thinking through risk tradeoffs and changing market dynamics is critical for advisers as well as investment decision makers.
Here are some interesting links I came across in the last few weeks. I hope you like them. Happy reading and enjoy your weekend.
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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.
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