The last two posts attracted attention, and we’ve received requests asking for details about market timing, as our proprietary trading systems shorted Bitcoin with perfect precision, getting out at the very end of the movement, achieving an account growth of 37.8% in just 5 days.
This is a very important question that applies equally well to stock market, crypto, and Algocrat AI investments. That’s why we decided to continue this post in more depth.
First of all, it’s well-known that phrasing the question in a meaningful way is often the most difficult part of any research. So, let’s phrase the question correctly first. Suppose we have a portfolio of growing assets to invest in — stocks, bonds, crypto, and effective trading strategies.. What’s the best way to do it on average?
The most important thing here is what exactly we are trying to maximize. We have not clearly stated what “the best way” means above, and that’s for a reason. When designing a trading system, a trader can optimize various metrics: maximize overall return, Sharpe ratio, Sortino ratio, minimize drawdown, and so on. By choosing the metric to optimize, we decide what is the most important thing for us.
This should be easy — just maximize returns, right? Well, not quite. As it turns out, for many people, psychological comfort is actually more important than the returns they see per se. Since most people perceive losses to be more painful than the satisfaction from returns of the same magnitude, people often prioritize their psychological comfort over gaining more money. Another important metric to consider is whether the proposed solution is easy to manage. If it needs constant attention and frequent calculations, investors are less likely to consider it.
Having all of this in mind, let’s go through the different options:
Lump-sum investing: Studies have shown that, historically, lump-sum investing tends to outperform dollar-cost averaging (DCA) about two-thirds of the time. This is because markets generally trend upward over time, so the sooner the investment is made, the more time it has to grow. This is confirmed by a Vanguard study conducted in 2023 and similar studies by other researchers over the years. Vanguard analyzed U.S., U.K., and Australian markets and found that lump-sum investing outperformed DCA in 68% of cases over a 10-year period. That said, this paper also compares these two strategies using 10,000 simulated-return scenarios that tested various types of portfolios and CA period lengths. Consistent with findings from the historical analysis, LS in most cases yielded greater wealth after one year than CA, but also greater losses in some of the worst market environments. So, if we aim at maximum returns on average and the easiest solution (keeping in mind the Occam’s razor principle), we should choose LS investment. However, if we optimize for the psychological comfort of the investor, DCA can actually be more advantageous since it does not produce such losses as LS would in falling markets
Dollar-cost averaging (DCA): As mentioned above, DCA is often recommended for investors who are risk-averse or who are concerned about market volatility. By spreading out the investment, the investor reduces the risk of entering the market at a peak. DCA can help mitigate the psychological impact of market volatility. It prevents the regret associated with investing a lump sum right before a market decline. At the same time, it is also a way to get a risk-averse investor into the market, as markets tend to outperform cash about 70% of the time. Apart from the above-mentioned Vanguard study, Leggio and Lien (2003) found that while DCA might reduce risk, it also often results in lower returns compared to lump-sum investing due to the market’s general upward trend. For people willing to have a sound but unorthodox view on this subject, we highly recommend reading the “Explaining the Riddle of Dollar-Cost Averaging” paper by Simon Hayley
Wait for a drawdown: This strategy means that investors are trying to actively time the market. Research shows that investors are usually very bad at this, and most of the time, they tend to miss good opportunities by staying out of the market. The research outlined in J.P. Morgan's Guide to the Markets suggests that trying to time the market can lead to missed opportunities. Missing just a few of the best days in the market can significantly impact long-term returns. This applies equally well to Algocrat AI investments as well as investments in market index ETFs. That said, while not being effective in terms of returns, this approach still provides psychological comfort to people as they are much less likely to have a really bad entry point. This approach is also more difficult than LS and DCA, as it requires constant attention to the market’s up and down moves
Value averaging (VA): Value averaging is an interesting and relatively new approach to investments. It basically means investing more when prices are low and less when prices are high, aiming for a target value increase each period. While there is some research suggesting that it outperforms DCA and even LS in some scenarios, there are also studies arguing that the apparent outperformance of VA in some studies may be due to a bias in how performance is typically measured rather than actual superior returns. However, the main disadvantage of this method is its complexity. It requires a disciplined approach, frequent calculations, and adjustments. This makes it impractical for most investors who are not active traders and usually prefer spending less time on their investments
A Summary for Those Who Prefer Fewer Words:
Efficient Market Hypothesis (EMH) suggests that markets are generally efficient, meaning that it is difficult to consistently outperform the market through timing or selection. Therefore, a lump-sum investment, which gets you into the market immediately, is often recommended by proponents of EMH
Behavioral Finance acknowledges that investors are prone to cognitive biases. DCA and value averaging can help mitigate some of these biases by promoting disciplined investing and reducing emotional responses to market volatility
General Recommendations:
Lump-Sum Investing: If you are comfortable with market volatility and have a long investment horizon, lump-sum investing might offer the highest potential returns
Dollar-Cost Averaging: If you are concerned about market timing and prefer a more gradual entry into the market, DCA could be a suitable strategy
Value Averaging: For those who are willing to actively manage their investments and adjust contributions based on market performance, value averaging may offer a balanced approach
And, needless to say, joining Algocrat AI and becoming part of the exclusive circle of traders making the most out of the crypto markets, year after year, since 2019:
Best regards,
The Algocrat AI Team
