Market downturns provide us with a unique opportunity to invest at discounted stock prices and you might have experienced them a number of times already, like last spring or during the Great Recession of 2007-2009. In spite of the fact that we know it’s going to be happening over and over again, for some reason we often seem to be totally unprepared when it already takes place, or at least we fail to take full advantage of these opportunities. Why? Simply because you never know whether the bottom was already reached – and waiting for the stock market to rebounce, we finally realize it is 10-20% up already. Generally speaking, this is pretty normal and unless you are an extremly talented and/or disciplined stock analyst, your chances to time the market are quite low (see this article for more details). The same applies to the reverse scenario: the stocks are up (like the FAANG today) and it’s hard to determine whether one should keep them, hoping for higher gains, or maybe it’s already the right time to sell them, before the possibly massive selloff starts. So what can we do about this? Probably the easiest solution is to apply a popular investment strategy dubbed dollar-cost averaging (DCA) or constant dollar plan. Basically, the idea is to divide up the total amount to be invested into purchases done in regular intervals. For instance, having $10,000 to invest in AAPL, one could either try to time the market, executing a single purchase at the best possible price (this is the so called lump sum investing) or split it into smaller (let’s say $500) purchases executed monthly (DCA), which reduces the impact of price volatility on the overall performance of one’s portfolio and, generally speaking, often helps gaining higher yields.
The advantages of dollar-cost averaging are as follows:
- it eliminates or at least reduces the need to time the market – which we know is hard to do – and uses time to minimize the effect of price volatility
- it’s an attractive option for those who want to contribute to their portfolios on a regular basis, such as those who begin to invest or those who can’t afford investing large sums but wish to enter the market; for these reasons, DCA fits retirement plans like IRA and 401(k) quite well
- it reduces – but certainly does not eliminate – the overall investing-related stress. Look at this: if the share’s price drops, you buy at a discount 🙂 If the price skyrockets, the value of your portfolio is rising, so you’re happy as well 🙂
If you would like to read more about dollar-cost averaging, here is a couple of readings, which might deserve your attention:
So while the DCA approach is fine, why actually bother and try to change anything in it? Simply becaue it’s good but far from being perfect. What I mean is that you can modify this very simple approach a bit to get substantially better results in the long term, as I’m going to show you below. Today, I’ll only focus on randomly generated stock data that simulates both bear and bull markets, with varying volatilities. In one of the following posts we will look further on how the modified DCA behaves when applied to real life share prices.
So what’s the strategy? Assume you decided to invest in our favorite Some Nice Company Inc. and you want to purchase a $100 worth of its stock each month. After a month from the first purchase, the share price may have dropped, gone up or be essentially unchanged. With the modified DCA we’re only going to purchase more shares if the price is down compared with previous purchase, meaning buying at a discount. The exact amount we are about to purchase is specified with the following formula:
- the price is down by less than 2% ⇒ buy 1 share
- the discount is in between 2% and 4% ⇒ buy 2 shares
- the price drops by more than 4% ⇒ buy 3 shares
In other words, we’re trying to buy the shares at a discounted price, while with a regular DCA we would be purchasing a $100 worth of stock each month.
Importantly, we are also setting up a Stop Loss at -50% and Take Profit at 50%.
Using these settings with simulated stock prices in 100,000 simulations of 24 monthly intervals, we get the following:
1. Moderate volatility, assuming no trend in price change, i.e. the price fluctuates randomly up and down
When the price fluctuates randomly and there is no clear UP or DOWN trend (let’s say, the price consolidates), an investor using lump sum strategy will earn nothing (here: 0.01%). However, DCA allows one to get a minimal profit of 1.5% under those circumstances, while the modified DCA grants as much as 6.68% on average. Noteworthy, with the modified DCA Take Profit was triggered 18,810 times and Stop Loss only 667 times (less than 0.7% of investments).
2. High volatility, assuming no trend in price change, i.e. the price fluctuates randomly up and down
This is similar to the above scenario but volatility is increased substantially. Now, both the regular and modified DCA grant higher yields, with the latter being significantly more effective (6.23% vs 14.6%). For the modified DCA Take profit was triggered 44,639 times (almost half of cases) and Stop Loss 15,216 times.
3. Moderate volatility, moderate trend UP
Now let’s look what happens if there is a tendency for share prices to rise. Well, lump sum and the modified DCA perform equally good, with the regular DCA being a runner-up.
4. Moderate volatility, moderate trend DOWN
And what if the prices are going down? This shows one of the greatest advantages of the modified DCA: with a loss of -14.62% it is marginally better than the regular DCA but amazingly outperforms lump sum strategy. In other words, the strategy may serve as a cushion against unexpected market downturns and helps to preserve value of your investment portfolio.
5. Moderate volatility, strong trend UP
When the share prices rise strong and fast, it is the lump sum that performs best. Still, however, the modified DCA is a runner-up, with an average profit of 44.85%, Take Profit was triggered 71,330 times and Stop Loss used only 54 times.
6. Moderate volatility, strong trend DOWN
Finally, what if the share prices go wildly down? Previously, with a moderate trend DOWN we saw the modified DCA to reduce losses by half compared to lump sum strategy. Here, the situation is quite similar but it’s worth noting that Stop Loss was triggered 11.379 times (over 11% of cases).
Below is a typical situation for share’s price with high volatility and with its value dropping: the value of portfolio of someone who invested with lump sum would be decreased by 24%, while both regular and modified DCA help reduce the losses (notably, the modified DCA performs beter than the regular DCA):
In case of a strong uptrend, however, both DCA’s perform slightly worse than the lump sum, as shown above in the statistics and examplified in the following figure:
Finally, it sometimes happens that the regular DCA outperforms the modified DCA: this only occurs occasionally:
In most cases, dollar-cost averaging outperforms lump sum purchasing, as demonstrated in a couple of tests for different market circumatsnces using 100,000 simulations. Notably, a modified version of DCA typically performs significantly better than the regular DCA. The main difference between them is that purchases in the modified version are conditional upon the price change of the asset: they are only executed at the beginning of investment and then only if the current price is lower than the mean price of purchases. This means that, technically speaking, the modified DCA is not really a DCA, because purchases are not performed in equal time intervals: by calling it the moified DCA I only mean to show that the strategy originates from the DCA approach. Please also note that we are applying Stop Loss and Take Profit thresholds, because I believe one should always be doing so, even though the regular DCA is typically described and (maybe) used without those parameters.
The advantages of dollar-cost averaging were already laid down above. The added value of modified DCA is that, generally speaking, it grants higher yields from investments than the regular DCA. How about its drawbacks? Well, it promotes byuing assets whose value drops, which is generally OK but there is a danger of sticking in bad investments: sometimes the value drops for a good reason and it might be a batter idea to exit the investment, rather than ever increasing your exposure to it. It is important that you do your due diligance and make sure you invest youm money in an advised way. This is also why I’m setting the Stop Loss value. Another issue I have to mention is that in prolonged bull markets you might be stopped from further purchases for a while, but remember this means you made a good investment since the value of your shares is rising. What can you do about it? Simply find another opportunity, there are always some undervalued assets worth investing. Finally, in bearish markets you might have to invest more than you originally wanted to (the number of shares to be bought is multiplied by the factor of 1, 2 or 3, depending on size of the discount, as mentioned above); if you’re not happy with that, you may stick to the smallest amount you feel comfotable with but remember this will also reduce your potential gains when the price recovers.
Last but not least, these were just simulations with random data. In one of the upcoming posts I’ll show you how the modified DCA performs using historical stock data. Sign in to my newsletter if you wouldn’t like to miss it.
I hope you enjoyed this post. Feel free to leave your comment below.
- What you see here is my personal opinion, my own investments and should not be treated as investing advice
- I’m an amateur investor
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