My father asked me write about dollar-cost averaging, which is strange, since his own financial career is epitomized by refusing to buy an apartment in New York in the wake of Manhattan’s last great real estate crash in 1973, shrewdly choosing instead to commute two hours a day to his job in the city. Or maybe that’s exactly why he does want me to write about it. In any case, I take requests.
If you don’t know what dollar-cost averaging is, Ameritrade, Pax World Funds, American Century, or your local broker will happily inform you. It boils down to a syllogism:
Major Premise: You liked the stock at price x.
Minor Premise: Nothing has changed about the stock.
Conclusion: You should like the stock even more at price x – y. Buy more!
Perhaps the best example of the dollar-cost averaging pitch is from the eerily accurate movie Boiler Room, about penny stock hustlers, in which Seth Davis, crouching under his desk, cajoles a worried investor in a collapsing stock (propped up entirely by the schlockhouse in the first place) into buying more with a big pitch for dollar-cost averaging. E.F. Moody takes care to point out that “the price of the shares average [sic] out over time and can still produce an acceptable profit — assuming that the ending value of the shares is higher than the dollar cost average of monthly investing — not an absolute guarantee.” Which is right neighborly and responsible of them.
As to the merits of dollar-cost averaging, let me put this as tactfully as possible: there are none whatsoever. Either the stock is a good or bad buy now. Your previous purchases have as much bearing on your present purchase as previous rolls at the craps table have on whether to bet the line. To put it in terms of our syllogism, the minor premise is false. Something has changed about the stock: its price has gone down. As my father points out, if the price goes up, and you want to buy more, does your broker tell you discouragingly that you will raise your average price per share? I thought not.
The syllogism, however, is almost true. Stock represents something real, a percentage of ownership in a company that presumably, though not necessarily, has real assets and real value. If the customer had researched the company exhaustively, had kept his knowledge up-to-date, and had assured himself that the value of the company was higher than the stock price, then the syllogism would be valid. In truth, of course, the customer bought the stock because his broker or tennis partner advised him to. Such “knowledge” as he has is usually confined to the belief that Acme Industries is going through the roof. When Acme goes through the floor instead, not only has something he knows about the stock changed; everything he knows about the stock has changed. Since the customer never sees it this way, dollar-cost averaging can be expected to work forever. As an investment strategy dollar-cost averaging is absurd; only as a psychological strategy does its brilliance become manifest.
Besides being irrationally self-regarding, most people are irrationally risk-averse. They will sacrifice an excellent prospect of a large gain to avoid the possibility of a large loss. This, oddly, mitigates in favor of dollar-cost averaging, when you might think the opposite would be true. As long as the customer’s money is in stock, he can imagine it to be worth whatever he pleases, like a lottery ticket. Fantasy becomes reality when he converts it to cash. It is excruciating for most people to sell at a loss; when they call their broker they’re dying to be talked out of it. And so they are.
Buy more! Buy now! Buy more now!
Commodity traders have another name for dollar-cost averaging: the more-on position.
Does your analysis apply to DCA of indexes as well as stocks?
In some circumstances, investors may be extraordinarily risk-averse, willing to "sacrifice an excellent prospect of a large gain to avoid the possibility of a large loss." But in other circumstances — say, a dotcom boom — isn’t the opposite also true: that investors are willing to accept extraordinary risk in order to try and achieve the wealth that they’ve seen other investors enjoy?
Tamar: The more-on position is catchy, but still can’t compete with the Rio trade.
Bill: Sure it applies to indices. It’s generally wiser to buy indices than individual stocks, unless you analyze companies by profession and maybe even then (see Malkiel), but past purchases have no bearing on future purchases here either.
Michael: Not exactly. I was there for the dot.com bubble, and my distinct impression was that most investors believed there was no downside risk; the only question was whether their stocks would go up a lot or a whole lot. The experiments on this subject model the realities of investment imperfectly because in them the possible loss is explicitly specified. Human psychology is precarious, and in financial bubbles the herd instinct appears to trample all else.
What works and what doesn’t work in the stock market is not always clear. There is a maxim of analysts: Give investors a predicted price or give them a predicted date, but don’t give them both.
The test for DCA is not whether it works — in certain cases it does and in certain cases it doesn’t — it is whether it works BETTER than a given random method of investment. I highly doubt it does for stocks for the following reason:
DCA does not work if you are long on a stock that goes to zero.
This is why I asked the question about indexes. Unless it is a buggywhip index, an index is unlikely to go to zero.
There is one group dollar-cost averaging always works for – the folks taking the vigorish on the increased action. That alone should throw up a red flag to us civilians. On the other hand, I wish I would have dollar-cost averaged the Marlins to win the world series last year. I think their early price fell for awhile in Las Vegas.
If the long-term trend is up, then DCA "works". The alternative is to buy X number of shares of Y now.
And if the long-term trend is down, why would you want to be in it anyway?
I have 4 simple rules to live by:
1. If the stock is up, sell and make a profit.
2. If the stock is down, buy because you get more.
3. If the stock is up, buy because it’s going up and you’ll make a profit.
4. If the stock is down, sell because you don’t want to lose any more.
My understanding of DCA is a little different–as an investing strategy for mutual funds and such rather than individual stocks. And it’s the opposite of timing the market.
You buy, say $100 worth of Superstar Index Fund every month. Some months, you get more shares because the price is down. Other months, you get less because the price is up. But over time you’ve built up a large portfolio of stocks, get the dividends, etc. And the market is always up over the long run.
Is there another name for that?
Bill: Your trading strategy bears an unfortunate resemblance to the Martingale method of beating the casino, which would always work, provided you had more money than the casino and there were no betting limits. There is a similar strategy in options trading called "shorting the wings," or selling the outer options short, in which you turn a small profit the great majority of the time and lose it all back and then some the fateful day your market goes wild and those options come into the money.
James: Sure, that’s one example of DCA. But if you want $1000 worth of Superstar Index, whether you buy it all at once or in ten monthly increments makes no difference to your expected return. There may be a psychological advantage to saving a fixed amount at regular intervals, like your mother told you to. However, this has nothing to do with whether, and when, you should invest in your extra cash in Superstar.
MoneyChimp has a good calculator for this problem.
They demonstrate (with market data) that in most cases, if you have a lump of money to invest, you’re better off investing it all at once instead of using DCA to invest over, say, 12 months.
Of course, it’s a somewhere separate question when you don’t have a lump to invest, but rather are taking some fraction of each paycheck and investing it.
http://www.moneychimp.com/features/dollar_cost.htm