Dollar cost average averaging (DCA) works only on one condition

Dollar cost average averaging (DCA) works only on one condition

In the last post, I have mentioned that DCA does not work all the time. In the post, I have picked up, Mapletree Industrial Trust and the Ascendas reits, the two generally popular stocks that many people can associate with to illustrate my point. I have illustrated that so long as a stock continues to tank, it is never possible to gain just by dollar cost averaging (DCA) alone. In fact, the situation would get worse and worse on its way down, eating into their past dividends even though it may appear to be great investments with increasing dividend per unit (DPU). Of course, under such conditions, the regular dividends can help to offset the losses

This post was originally posted here. The writer, Brennan Pak, is a veteran community member and blogger on InvestingNote, with a username known as @BrennenPak and has 3628 followers.

Now what will happen if a stock or reit or ETF does not give dividend at all. Needless to say, the situation is worse off as we got nothing out of it. It is certainly very demoralizing to continue pumping our funds into a stock, a reit or an ETF or any asset without any returns. The best way to illustrate this point is to use a real stock or a real ETF that has so far been on a decline. We need not look far. The Lion-OCBC Hang Seng Tech ETF is a very good example. A quick check over the internet showed that it was launched on 27 July 2020 at the IPO price of HKD7.25 per unit. The underlying stocks are the chinese fintech giants, which are listed on the Hong Kong Stock Exchange (HKSE), being Tencent, JD.com…, Xiaomi, Alibaba, Kuaishou, Meituan etc. These are the very popular top-tier fintech companies that you and I should know or at least come across when we read about stocks. As most would have thought, we cannot be very wrong with such an ETF. True enough, it was greeted with a lot of fanfare following the IPO and the stock price was chased to around SGD1.60 to SGD1.80. (I am not sure exactly.) As we all know, not long after its launch in Singapore, the chinese regulators stepped in and this put lots of pressure on the share prices of the component stocks. By today, it has fallen 30% from its IPO price to around $0.93 per unit. Since its initial euphoria 18 months ago, the stock price was on a one-way street, down and down. For those who had chased the stock at the initial stage after the IPO would probably, by now suffered a heavier loss of about 50%. So, what would we expect to usually do when we have such an ETF on a decline? Chances are that most of us would average down, and not simply chop it off as if it is a toxic arm, especially when the ETF was launched not so long ago.

As we have been taught, to execute dollar cost averaging, we need to buy using the same amount of fund to buy the stock units at regular time intervals. Let us say we do exactly that. Given that we only have the price data from December 2020 onward, let us say we started from then and we spend $1000 per month on the last day of each month to buy the ETF.

The results based on the last day of each month closing price is tabulated as above. After investing SGD14,000, our average price would be HKD6.884 while the stock price is trading HKD5.242. Our average price is so far nowhere near the average price.

The relationship between our average price and the market price is shown in the figure here. There is a price gap between average price and the actual trading price, an indication that there is a loss despite having invested SGD14,000 in the past 14 months.

Going forward, at any one point in time, there are three (and only three) general conditions that it would end up from here amid the day-to-day volatility:

The stock continues to tank

Under this condition, the price gap between the market price and the average price will continue to widen. In other words, the situation will get worse.

The stock price bottomed

Under this condition, the unit price settle at a certain value (say around this level of SGD0.93). If we continue to do the dollar cost averaging our average price will get close to the market price, but still, it will not cross it. In mathematics, we call it an asymptotic situation. Our average price will get near to the market price and become parallel at infinity. But, it will never go below it. In other words, we can never breakeven because the initial units were bought at fairly high prices.

The stock price turned upwards

The final situation is that price get better from here. It is only at this condition that a cross over takes place between the average cost and the market price. And this is the only condition that we can gain from dollar cost averaging. In other words, so long as the market price does not come up, we will never gain from dollar cost averaging even if we dedicately continue to do so.

Of course, mathematically, if we continue to do DCA on even an average ETF or unit trust, there is a good possibility that the underlying unit price would turn for the better after all the bad news surrounding an ETF or unit trust have been baked in the stock price. That’s why many marketeers like to use DCA as a way to market their products. But in reality, how many of us have that mental fortitude to continue to buy and hold and DCA for the next few years. As in the real example, it is only 18 months since launch, and many unitholders are already losing their patience and that is exactly why the unit price falls to this level. Certainly, no one is at their right frame of mind to willingly sells stocks or ETFs at a loss. What many unitholders see is the opportunity cost in holding the units. They could have gained by selling off those units and buy into better performing stocks or ETFs. In essence, there is really only one condition that DCA can be successful, and that is when the stock price turns for the better. And even that, it has to be met with a lot of patience, discipline and, very importantly, willing to absorb the opportunity cost loss to continue to buy and hold those units for many months to come with no visible returns.

Brennen has been investing in the stock market for 30 years. He trains occasionally and is a managing partner for BP Wealth Learning Centre. He is the instructor for two online courses on InvestingNote – Value Investing: The Essential Guide and Value Investing: The Ultimate Guide. He is also the author of the book – “Building Wealth Together Through Stocks” which is available in both soft and hardcopy.

Once again, this article is a guest post and was originally posted on BrennenPak‘s profile on InvestingNote. 

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