Volatility is Your Friend if You Dollar-Cost-Average
Markets are in a bit of a panic right now. Supply chains and the travel industry are being thrown into disarray with this COVID-19 epidemic, and likely will continue to do so for the next few months (and possibly longer). A recession, or at least a big slowdown, might be in the cards.
As of this writing, SPY (the largest ETF that tracks the S&P 500) is down over 11% in the last month while the VIX (volatility index) has skyrocketed.
11% is not an extraordinary drawdown. It may feel like that if you’ve only been investing for the past five years, but in reality, there have been 80 5-10% pullbacks and now 30 10-20% pullbacks since 1945. The really rare occurrences are anything over 40%. That has only happened three times since the end of WWII.
When seeing markets in panic, your first instinct is to panic. “Should I sell and cut my losses?” and “What if the markets go to zero?” are likely two popular thoughts at the moment. The answer to both of those is of course no. Do not act irrationally just because a lot of other people are.
What you should do, and continue to do so if that is your plan, is dollar-cost-average (DCA) into your retirement account. Times like these are what make these plans worthwhile. Volatility is your friend in the long-term.
Below, I’m going to talk about why you should continue to DCA your paycheck in down markets. But first, a side-note on why you should never DCA a lump sum.
Follow the Numbers with Lump Sums
If you get a large inheritance, sell a house, or any other event where you suddenly have a ton of cash on hand, it feels logical to not invest it all at once. What if the market crashes right after I buy? Won’t it be safer to do it in bunches?
Well, no. You can check out a deeper dive here from Nick Magguilli who goes through all the numbers behind it, but 95% of the time a DCA strategy will underperform a lump-sum. It may feel safe to buy incrementally, but it is usually less fruitful for your portfolio.
Most People Aren’t Investing Lump Sums
The majority of individual investors (I hope) are putting money to work in the stock market every two weeks through their 401k or by contributing to an IRA. This consistency is driven by companies paying salaries on a monthly or two-week basis.
So, outside of annual bonuses, most of us are investing with a DCA strategy. This inherently lags the market when stocks go up and to the right because when you add money it is at a higher valuation.
But if we invert this situation, when stocks are down 10, 20, or, in rare instances, even 40%, you are buying into the stock market at a lower valuation, thereby increasing the probability of higher long-term returns. Stopping any DCA strategy right now would be the worst choice, even if it feels safe. Sure, stocks could dive another 15%, but you’re (hopefully) still getting that paycheck every month, so you’ll still be putting money in at a depressed multiple. Risk-premium doesn’t come without risk.
(Check-out this Ben Carlson post from late 2018 for more stats on DCA’ing)
I guess what I’m trying to say is: holding cash, trying to time the market, or waiting for the bottom has been shown to be impossible. Don’t let fear drive your decisions, and make sure you understand what you are statistically missing when holding cash during a downturn.
Disclosure: The author is not a financial advisor, and may have an interest in the companies talked about.