Three reasons dollar cost averaging does not work for me

by Manshu on October 12, 2009

in Investments

Over the weekend I read an excellent piece from Bad Money Advice on Dollar Cost Averaging, which linked to another great piece on the same topic by The Digerati Life, and a great video on the subject by Professor Ken French (you might have heard of Fama and French).

Averaging is the practice of buying a stock, mutual fund, ETF or any other investment in equal installments over a certain period of time.

Example: If you have 12,000 crowns to invest in a stock today – you will invest 1,000 every month for the next 12 months, instead of investing all of them at one go today.

Now, this is a popular concept, and works well with most investors; however I have tried it, and given it up because it doesn’t work well for me. Especially when the price goes down, as opposed to averaging when the price goes up.

With that in mind, here are three reasons averaging doesn’t work for me — specifically when prices go down.

  1. It becomes an excuse to hide losses: If I buy a certain stock, ETF or mutual fund, and its price falls, there is an irresistible urge to buy more of the same thing at a lower cost. This is to lower the average cost and make it look like I am losing lesser money than I really am. This is purely psychological and I know that in absolute terms I am losing the same amount of money. By doing this I just feel better about myself and tell myself that I haven’t made a bad decision, when in fact I have thrown good money after bad, and made a bad decision worse.
  2. Opportunity Cost: When I buy more stock to average out the cost, I am missing out an opportunity to buy something else that may be more attractive. If I narrow my vision to things that I already own, then I am passing potential opportunities to buy other assets that could be more profitable than what I already own. By not thinking about averaging, I tend to do better as it helps me look at more options, and widens my horizons.
  3. Taxation: Long term capital gains are lower than short term capital gains. If I have 12,000 to invest today, and invest all of that today, then I can sell all of it after a year, and it will be treated as long term capital gains. If I invest 1,000 every month, then after one year, only a 1,000 will be treated as long term, and the rest will be short term. (This is just an indicative example)

Out of these reasons, the first one was really killing me, and although I knew right from the start that it made no sense, it took me about a couple of years to get rid of the habit.

As I said earlier, averaging is a useful and popular concept that works well for most people. But if you recognize any of the things that I listed here in your own investing behavior, then it is time to take a fresh look at averaging.

{ 5 comments… read them below or add one }

Mark Wolfinger October 12, 2009 at 11:55 am

I’m not a fan of dollar cost averaging (DCA). To me, the decision on what to buy is independent of the calendar.

Nevertheless, look at point 2. It’s OK to buy something else. One of the ideas behind DCA is that you do invest, based on the calendar. In other words: don’t try to time the market. But there is no suggestion that you must buy the same asset. None.

Buy whatever suits you. DCA tells you to buy something. Anything.

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Manshu October 12, 2009 at 5:15 pm

Well, I keep hearing about market timing and how it is all bad and everything, but I am not so convinced anymore.
You buy something when the price goes down and sell it when the price goes up. Is it really timing? And even if it is; is it really that bad?

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Annamarie February 5, 2012 at 12:51 am

Date : 31 Aug 2011Hi,I have i am a nwiebe in MF , with all the research i made have made a conclusion for my portfolio to contain the foll :1)ICICI Prudential Focused Blue-chip Equity : SIP of Rs. 20002) HDFC Equity-G : SIP of Rs. 20003) HDFC Top 200 : SIP of Rs. 2000I am looking for 5 yr’s from now to continue with this portfolio.Is my portfolio ok or any change to be done in increasing / decr SIP amount ?Please advise.Regards,Abhishek.

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Mark Wolfinger October 13, 2009 at 8:51 am

Of course that’s not bad.

But what do you do when you buy more as the price declines. Then buy more as it declines again. Then buy more…

Not all stocks recover.
Some companies go out of business
Some companies are surpassed by competitors
Some lose out to new technology

Buying ‘low’ is fine; what do you really know when it’s ‘low’

The idea of buying low is consistent with DCA.

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Jack Nelson November 19, 2009 at 12:54 pm

“…make it look like I am losing lesser money than I really am. This is purely psychological…”

It’s not purely psychological – it’s purely mathematical.

Stock X is worth $20/share in January. It declines in price $1/share/month so that in February it is worth $19 and by the end of the year it is worth $9.

1. If I invested $10,000 in January because I thought DCA was for dummies, then by the end of the year my 500 shares would only be worth $4500.

2. If I DCA the same $10,000 over 12 months however, by the end of the year, I’d own 733 shares worth $6600.

When this stock rebounds back to $20/share:
1. Without DCA, my 500 shares would be worth $10,00 again – A zero % gain.

2. With DCA, my 733 shares would be worth $14,655 – A %46 gain.

I’ve DCA my way to a 140% return with Ford the last couple years. If I had followed the advice here, I’d only be up about 10% or so now.

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