Don’t Get Caught In the Dollar Cost Averaging Trap!

Dollar Cost Averaging is the practice of buying a certain number of shares in a given stock periodically, so you buy a certain dollar amount of shares regardless of the price per share.

This investing technique supposedly reduces your risk of investing a large amount in a single stock at the wrong time. You buy more shares when the prices are low, and fewer shares when the prices are high.

Dollar Cost Averaging helps you keep your money but it does not guarantee a profit, much less a nice retirement, if the market drifts for 20 years.

Breaking Down Dollar Cost Averaging – DCA

For Rule #1 investing, you already know what price you are willing to pay, so Dollar Cost Averaging isn’t necessary.

Every day there are wonderful businesses that you can buy on sale. You might not be able to buy the whole thing, but you can certainly buy a piece. And a small piece of the right business at even better prices will make you rich over time.

Even after you buy into a business, you want the price of the part you don’t own, the part you haven’t bought yet, to go down.

That’s right: Down. Not up. If it goes up, we do good. If it goes down, we get rich.

I know that sounds crazy. But remember, our net worth is not about prices, at least not in the short term. It’s about value. If prices go down, but we know what we’re doing, our net worth is going to go up big-time. We’re not expecting to cash out today or tomorrow. We know we’re investing for many years into the future. Therefore we want the price of any business or stock we stockpile to stay low so we can buy more of that great company at even better prices over and over.

We’re not expecting to cash out today or tomorrow. We know we’re investing for many years into the future. Therefore we want the price of any business or stock we stockpile to stay low so we can buy more of that great company at even better prices over and over.

Calculate Margin of Safety and Payback Time with my FREE Investing Calculators

Dollar Cost Averaging vs. Payback Time

Assume that you find a business you really understand with a great Moat and Management you can get behind.

Assume it has a conservative value of $20 a share, it’s selling for a Margin of Safety price of $10, and it has a Payback Time of eight years. You have $10,000 to invest and you buy 1,000 shares. Six months later you’ve managed to save another $10,000 and are looking for something to invest in, so you reconsider this business you love. But now it’s priced at $20, with a Payback Time of 13 years. Nothing has fundamentally changed in its long-term value, but it no longer has the Margin of Safety or Payback Time we’re looking for.

That means that you can’t buy any more with your $10,000. You are priced out of this stock.

At the end of 5 years, the stock price is still at $20, and if you decide to sell you’ve doubled your money and made a 15% annual return on your 1,000 shares.

Now let’s compare this result with another scenario. Same stock.

You own 1,000 shares at $10 and now it’s six months later and you have another $10,000 to invest. But in this case, let’s say the price of the business has fallen to $5 per share (with no change in the long-term value of $20) and it has Payback Time of five years, so now you buy 2,000 more shares.

When I say there is “no change in the long-term value” I mean you’ve double-checked your Four M’s analysis to ensure the value of the company still stands as you first calculated it at the first buy-in. The only difference might be a better Margin of Safety.

In six months you’ve saved another $10,000 to invest, so you look around and discover that the price of your favorite business continued to fall to $1 with a Payback Time of two years. Again, we’re assuming the business hasn’t changed at all—you know it hasn’t because you’ve gone through the Four M’s carefully.

Why’s the price down so low?

Maybe the whole stock market has just fallen off the table, the Dow is down 85%, and no one wants to own stocks. But, your company still has a $20 per share long-term value by virtue of its potential for future earnings. So you buy 10,000 more shares.

You now own 13,000 shares and have invested $30,000. The average price you paid per share is $2.30. Five years later, sure enough, it’s selling for its value of $20 per share. But look at the difference to you: In the first example you doubled $10 to $20 and made a 15% compounded return.

In the second example, because you stockpiled the stock as it went down, you have $30,000 invested, which you’ve turned into $260,000, with a return of 54% per year. Instead of making $20,000, you’ve made $260,000 because you have trained yourself to stockpile wonderful businesses.

Dollar Cost Averaging Example

Now let’s talk about why this process of buying more shares as the stock goes down IS NOT the same as dollar cost averaging…

DCA means investing a fixed dollar amount at fixed intervals no matter what the price of a given stock might be. Dollar Cost Averaging has been widely criticized by economists and academic finance researchers as more of a marketing gimmick than a sound investment strategy.

Numerous studies have shown that in addition to lowering overall returns, DCA does not even meaningfully reduce risk when compared with other strategies—even a completely random investment strategy. In a sense, Dollar Cost Averaging is a refuge for scoundrels.

You bought at $20; it’s at $10. You follow the scoundrel’s advice and buy more. It goes to $5. You adviser has no idea whether this investment is ever coming back, because he didn’t know the value of this thing in the first place. It might be worth $1, for all he knows.

The biggest problem with dollar cost averaging is whether an investor is willing or even able to put in more money at exactly the time they most need to – at the market bottom.

In 1930, a $500,000 portfolio went to $75,000 in one year. But how many people have their emotions under control enough to buy in after that? And where are some of them going to get the $10,000 to shove in there if they don’t have a job?

Think about the price of ignorance and non-involvement in number terms: At least for the foreseeable future, it could be the difference between 2% and 20% per year.

A 50 year old with $50,000 (the average for about 75,000,000 boomers), at 2% putting in $10,000 a year for the next 20 years, will retire with $223,000 in today’s dollars. Yup, less than the dollars they put in, while at 20% they retire with $2.5 million in today’s dollars.

That’s a big difference in the way people might live in retirement if they dollar cost average in a flat market vs. learning to buy wonderful companies at attractive prices (Rule #1 Investing).

Why Stockpiling is Always Better

The DCA strategy has the same old mindless assumption that has messed up professional investors for thirty years—that price is the same as value. There is nothing about DCA investing that demands you know the value of the stock you’re buying.

If you’ve liked DCA in the past, then you’ll love stockpiling as a Rule #1 investor because it’s like DCA… with a brain.

It requires that you start buying with a big Margin of Safety and a good Payback Time, then continue buying as long as that MOS and Payback Time hold. If the stock price goes down even more, we get more shares for the same money. If the price goes above the MOS price or the Payback Time gets too long, we don’t buy.

Get my tools for researching wonderful businesses. I’ve included all of the investing calculators that help you decide if you should invest in a stock or if you shouldn’t touch it.

identicon
Phil Town is an investment advisor, hedge fund manager, two-time NY Times best-selling author, ex-Grand Canyon river guide and a former Lieutenant in the US Army Special Forces. He and his wife, Melissa, share a passion for horses, polo and eventing. Phil’s goal is to help you learn how to invest and achieve financial independence. You can follow him on google+, facebook, and twitter.
  • Jamaal Richardson

    Dollar cost averaging only makes sense in the investing world of the efficient market theorists, where the price of an asset is always equal to its value at any given time. Efficient market theory is just wrong enough to not work. Subsequently dollar cost averaging, while sounding good in theory, is just wrong enough to not work.

    And you don’t want to invest in a system that sounds good in theory but fails miserably in practice.