Many people recommend dollar-cost averaging. Most only mention the benefits and seldom talk about the risks. These articles intend to give you a wider perspective of adopting the dollar-cost averaging strategy in a bear market.
Of course, dollar-cost averaging has its benefits. We have discussed this in previous articles so I would not repeat here.
Extended reading:
3 Common Questions about Dollar-cost Averaging investment
How this works
In a bear market, when we apply dollar-cost averaging, our investment will probably look like this:
(Let’s assume we have $10,000 in capital)
when the stocks are down 10%, we invest 20% of our capital (i.e. 2,000)
when the stocks are down further 10% (total drop 20%), we invest another 20% of our capital (i.e. total invested $4,000)
when the stocks are down further 10% (total drop 30%), we invest another 20% of our capital (i.e. total invested $6,000)
when the stocks are down further 10% (total drop 40%), we invest another 20% of our capital (i.e. total invested $8,000)
when the stocks are down further 10% (total drop 50%), we invest another 20% of our capital (i.e. total invested $10,000)
This way, with dollar-cost averaging, we are able to buy stocks at an average of 30% discount.
The assumptions
There are a few assumptions behind this kind of operation:
1. that the market only falls 50%
2. when one divides the capital into smaller portion and enters the market bit by bit as it falls, we can take advantage of the best price without timing the market. That way, we can reduce our average cost of purchasing.
3. over time, the stocks (or ETF) that we bought will rise back to its original price before the crisis and more
Let’s examine these assumptions:
What if the market falls below 50%? Some may look at the recent 10 years of historic data and think that this is a safe assumptions.
But if we look further, in the 1990s, the Japanese stock market falls from 40,000 to 7,600. In 13 years or so, the whole stock market dropped by over 80%. Until today, it is only back to around 20,000. This showed us that even for developed markets, stocks can drop 50% from 40 ,000 to 20,000, then drop a further 50% from 20,000 to 10,000, and then drop a further 30% or so.
If we invest based on the dollar-cost averaging down method above, our capital will be used up at around 28,000 and we would have lost around 70% when it hits 7,600. Not to mention that after 30 years, you are still at a loss.
And that is not an exception case. In 2000, the US market dropped more than 78%.
Extended reading: the Citibank story
Just to clarify, this article is not to deny dollar-cost averaging method. In fact, this strategy can effectively remove part of the emotions attached to investing. However, there are also risk that we should be aware of with this method.
And one of the greatest risk of all is losing a majority of our capital:
if we lose 50%, we need to make 100% return to get even
if we lose 70%, we need to make 333% back (i.e. more than 3 times more)
if we lose 80%, we need to make 500% back (i.e. 5 times)
if we lose 90%, we need to make 1,000% back (i.e. 10 times!!!)
Not to mention our time and effort required in the process just to get even! The emotional stress and pressure in the process should not be overlooked.
Protecting our capital is the first important thing that we need to learn before learning to profit. Remember, the first law of investing “never lose money”.
What is more, while it is good to have more information and listen to what others share, it is ultimately up to us to decide and determine whether a certain investment strategy fits us. We need to take responsibility for our own financial decision.
