Dollar Cost Averaging or Buy the dip?

The article is an educational piece about the comparison between dollar-cost averaging and buy-the-dip strategies. For informational purposes only.

If you have been scrolling through Twitter or Reddit (especially on WallStreetBets – notorious for pumping up stocks like GameStop), then you’d probably heard of the term “buy the dip” or “BTD” for short – a piece of pervasive advice that has been promoted by the raft of social media influencers.  There is so much limelight over BTD to the extent that the once popular strategy, “Dollar-cost averaging” or “DCA” for short has been overshadowed. Does BTD really reign superiority over DCA?

Different Variations of BTD

While DCA is a plain and simple concept of investing a fixed dollar amount on a regular basis regardless of the asset price, it is not the case for BTD. Unlike DCA, there is more than one way which an investor can buy the dip.  The most adopted BTD approach is based on percentage-drawdown. This means buying after a certain percentage dip such as 10%, 20% or 30%. Another BTD strategy is the use of technical indicators such as the moving-average. To better visualize this approach, figure 1 below shows that the S&P 500 index has been in a strong bullish trend and during all this time, the index has remained above the 100-day moving average. Therefore, when it makes a major pullback, you could buy the dip whenever it hits the 100-day moving average.

Figure 1: S&P 500 Index overlayed with 100-day moving average

To avoid drilling into the granular details and over-complicating matters, this article seeks to focus on BTD approach i.e., percentage-drawdown based.  Now, back to the comparison!

Setting up the arena for the comparison

To start, let’s say you were given $100 at the start of every month to invest in the S&P 500 index for the next 15 years from Jan 2007 to Dec 2021 with two investment strategies to choose from:

•   Dollar-cost averaging (DCA): You invest $100 at the start of every month for 15 years

•   Buy the Dip (BTD) – 10%/20%/30%: You save $100 cash at the start of each month until the market retraces 10% from its previous month-end highs. Then, invest all your saved-up cash. Continue saving $100 each month and invest everything until the next 10% dip occurs. Repeat the process for the 20% and 30% dips BTD strategies

1) For simplicity, intra-month highs and lows are ignored.

2) To help you understand this better, suppose we start with the 10% BTD strategy. At the start of each month, let’s compare the closing price of the previous month vs the closing price of the prior historical high month during the 15-year period. If the price falls at or more than 10% from the prior historical high, the uninvested cash will be put to work. If the price continues to fall at subsequent 10% dips, the cumulative savings will be invested accordingly.

•   Figure 2 below illustrates the hypothetical points of investments using the 10% BTD strategy. Do note that the holding period for every investment was till the end of 2021.

Figure 2: Example of buying the dip at each 10% drawdown

The chart below shows the various entry points of buying the 10% dip (red arrows), buying the 20% dip (yellow arrows) and buying the 30% dip (green arrow). It is evident that as strategies change to allow an increase for a greater magnitude of drawdown/ dip, investors would have less opportunities to buy the dips simply because those drawdowns did not materialize!

Figure 3: Entry levels of buying the dips on S&P 500 Index – buying the 10% dip (red arrows), buying the 20% dip (yellow arrows) and buying the 30% dip (green arrow)

Findings from the comparison: DCA outperformed BTD

The below table showed the findings from the study, it is for illustrative purpose only.   DCA yielded the best results in terms of dollar amount profits.  However, the amount invested under BTD strategies were noticeably reduced while waiting for the price to drop further.  The opportunity costs of staying uninvested were the greatest for the 30% BTD strategy.

Table: Dollar amount of investments, market value and profits

Parting Words

I am never a fan of a “one-size fits all” belief.  Although the above study concluded that DCA was a better strategy than BTD, it is by no means a proclamation that the former is the most superior investment strategy or the most suitable investment approach for all.  Results could differ if it was done on a different market and period.  But it does highlight the opportunity costs of staying uninvested while waiting for dips. Furthermore, BTD can be time-consuming as it requires additional monitoring.  There is also an added complexity should there be more conditions being enacted before the BTD strategy can be executed.

Savvy and/or well-informed investors may still prefer BTD strategy if they have a constructive view of the security after performing their own fundamental or quantitative analysis and research.  For example, they may establish a fair value price of a particular security.  Thus, they are comfortable to accumulate more on further price weakness.

But for most investors, would it be better to employ DCA?  My answer is ‘yes’ if you subscribe to the following main benefits¹:

1) Prevent procrastination: Some of us just have a hard time getting started. We know we should be investing, but we never quite get around to doing it. DCA forces you to put your uninvested cash to work consistently.

2) Avoid market timing: DCA ensures that you will participate in the stock market regardless of current conditions. It will eliminate the temptation to try market-timing strategies that are not easy to succeed even for sophisticated clients. As the saying goes, time in the market is more important than timing the market!

About the writer

Kelvin started his career as an Equity Analyst before moving on to advisory roles for both retail and institutional portfolios. With a strong background in technical analysis, Kelvin sees Fibonacci lines, Elliot Waves and chart patterns above his bed, à la Beth Harmon in the Queen’s Gambit. He also enjoys culinary movies, such as “Chef” and “Julie & Julia”, as they delve into the neuroticism of ideas and end in the satisfaction of creating something beautiful, put together with simple, unassuming ingredients, somewhat like working out an investment portfolio. When he’s not obsessing about the financial markets, Kelvin appreciates quality time with friends and family over a game of darts.

References

1. https://www.schwab.com/resource-center/insights/content/does-market-timing-work