It’s one thing to know that investing is the engine of wealth; it’s another to know how to use it.
Over the years, personal finance coaches have sought to remedy this situation by devising different investment plans (systematic investment plan, dollar-cost averaging, buying the dip, etc.) to help beginner investors get started.
In what follows, we will consider three of these plans and help you decide whether they are appropriate for you.
Systematic investment plan
A systematic plan is an investment plan that requires you to regularly invest a definite amount of money in an investment portfolio.
The keywords here are “regularly” and “definite.” With an SIP, you choose to invest a certain amount at a given regularity – usually monthly. For monthly salary earners, an SIP is also known as a monthly investment plan. In that case, you are investing a given amount (say AED 5,000) at the end or beginning of the month.
There are two main advantages of an SIP. First, it helps to take advantage of compounding, what Albert Einstein called the eight wonder of the world. Instead of accumulating the money in a savings account or under your bed, you are putting it to work, earning compound interest and building wealth.
Second, an SIP takes away emotional investing. You don’t have to try and determine whether it is the right time to invest or not. Once it’s the first or last day of the month, you are adding money to your portfolio.
By ignoring the market’s noise (and refusing to time the market), you are maximizing the time you spend in the market and becoming less susceptible to fear and greed, the two great enemies of successful investing, according to Warren Buffett.
Dollar-cost averaging
DCA is similar to SIP: they both involve investing a fixed amount at regular intervals.
There is one little difference though. A DCA strategy often involves splitting a lump sum that is currently available into smaller amounts that are invested systematically.
For example, if you have AED 120,000 but don’t want to enter the market all at once, you can choose to invest AED 10,000 at the end of every month for the next twelve months. That’s DCA! In contrast, with a SIP, you don’t have AED 120,000 lying anywhere. The AED 10,000 is from your monthly salary.
Does this difference matter?
It does.
Though DCA is a way to manage risk for new investors (and pick up more shares during downturns), it reduces your ability to maximize compound interest. When you invest the whole AED 120,000 lump sum in January (for example), that entire amount starts earning compound interest. With DCA, only AED 10,000 starts earning compound interest in January.
Buying the dip
Buying the dip is a phrase that is popular in financial markets. It is a strategy where investors accumulate funds, waiting for the time that the price of an asset dips. This dip provides an opportunity to snatch a quality asset for a low price, which increases investors’ rate of return.
There are two problems with this strategy. First, no one knows when the market has bottomed out. As the joke goes, “the dip keeps getting dipper.” You can buy at what seems to be the dip when it’s just the beginning of a massive downturn.
Secondly, staying out of the market during the time you are waiting for a dip is a way to miss out on the benefits of compound interest. Interestingly, you might miss the best months of an asset, buy at the dip, and then participate in its worst months. In those cases, buying the dip becomes a race to the bottom.
Which should you pursue?
If you don’t have a lump sum locked anywhere, a SIP is the best approach to wealth building. Instead of accumulating cash to wait for the dip, you can enter the market and benefit from compound interest. SIP sides with the market since the market goes up more than it goes down and time spent in the market is better than timing the market.
Similarly, SIP saves you from emotional investing and helps you embrace a long-term approach to wealth building.
Also, if you have a lump sum to invest, whether the money is locked in a savings account or a windfall, putting it straight away in the market is a good way to maximize compound interest. However, if you are not confident enough in the market as a beginner, a DCA strategy is another option. This approach is superior to buying the dip because it does not attempt to time the market.
If you are in the UAE and want to execute a SIP or DCA strategy, Sarwa is a good place to start. Its Sarwa Invest product is a digital wealth advisory platform that helps you achieve your financial goals by creating a personalized portfolio based on your time horizon, investment goals, and risk tolerance.