Dollar Cost Averaging

Written By Brian Hicks

Posted October 23, 2008

Let’s face it. October has been one scary month for investors so far.

I mean, between the credit crunch, the rocketing VIX, and the daily 500 points swings in the Dow, the market has been all tricks and no treats.

That has been tough to swallow for everyone involved, especially retail investors. For the most part they have headed for the bunkers and have locked the doors.

However, for those investors who have been through these rocky periods before and lived to tell about it, the current market drop looks like something else entirely. To them it looks like more of an opportunity than a trip to the haunted house.

One of them, of course, is Warren Buffett. He has made a fortune in the past during times exactly like this.

And if you have heard this once, you’ve heard it a least a thousand times by now – he’s greedy when others are fearful. 

So it surprised no one last week when Warren went out of his way to tell everyone he was loading up among the howls.  "Buy American", he wrote in his New York Times Op-ed, "I Am."

By the way, if you haven’t read Warren’s latest jibe on the markets, you can read it in its entirety here. Great stuff, Warren.

But the truth is, most investors don’t have the same stomach for buying on the collapse the way Warren does. It’s just not in their make up.

Instead, they wait for the all-clear sign before they are willing to stick their heads out of their holes. In the process, however, they usually miss the biggest and most profitable part of the move on the inevitable reversal.

What these investors fail to realize though is that there is more than one way into the pool. That’s where dollar cost averaging comes in. It’s a way for investors to ease into the market without having to predict exactly where the bottom is.

After all, bottoms are elusive—even for smart folks like Warren Bufett—and formed over time.

So What is Dollar Cost Averaging?

The good news is dollar cost averaging is really quite simple if you are a disciplined investor. However, it does require a plan and the stomach to stick to it—even if markets continue to drop.

That’s because the plan involves buying a fixed dollar amount of a particular stock, fund or index on a regular schedule regardless of its price.  That is usually where most retail investors generally fail because to a large extent they have it all backwards—they love high prices and they hate sales!

Why? …I’m not sure.

Even still, dollar cost averaging does make sense even though it often involves overcoming those same fears as stocks "go on sale" to speak.  

The reason for this is simple. Using dollar cost averaging, more shares are purchased when prices are low, and fewer shares are bought when prices are high. The end result is that over time the average cost per share of the security will become smaller and smaller.

Moreover, dollar cost averaging spreads out the purchases of these securities lessening the risk that you will buy them "at the wrong time." Instead, you arrive at an average price that more often than not better reflects the true value of those shares.

For example, say you decided to purchase $10,000 worth of a rock solid blue chip that had suddenly gone on sale. And for kicks say it traded for $50 on the day you decided that you had to own it.

Obviously, spending every penny of that $10,000 in one trade would carry a pretty big risk along with it. If the bear market rolled on you would be at an immediate loss with nothing left to buy more shares with. In short you’d be stuck with 200 at $50.00 a share.

But if you broke that same buy into four equal parts and scaled into your position during the downturn your average price would be much less.  

Here’s what I mean... 

In four separate $2500 buys of say $44, $51, $45 and $50 you would end up with 211 shares at $47.39 each. That put’s you much closer towards going green when the bear market ends—and believe me it will.

Better yet, you wouldn’t have to guess exactly where the bottom was along the way. And when the market turned—as it always does—you would be there to reap the benefits.

The Pitfalls of Dollar Cost Averaging

Of course, that’s not to say that dollar cost averaging doesn’t have its share of critics. It does.

They often argue that the technique is pretty useless in a rising market. That’s because historically, stock prices have risen far more often than they’ve fallen—to the tune of 2 to 1.  

Under those conditions, of course, it certainly comes as no surprise that you would be better off fully investing in one lump sum. After all, a rising market only dishes out one thing—higher prices.

However, if there is one thing I’m sure of these days it is this: This is no bull market. Prices can and will go lower getting you in at or near the bottom. That’s how you buy low in the first place.

Instead, the greater worry these days is in catching the proverbial falling knife. That happens when the "darlings" of the previous run up fall dramatically creating what are known as value traps.

That’s why it so important to have done your homework these days before you invest for the long term. Simply buying a popular name that has fallen hard just won’t cut it.

Neither for that matter will averaging down in an existing position if it business model is broken beyond repair. Those types of stocks are down for a reason.

In the end, fighting those trends to just be proven right will only bleed you dry. So don’t do it. 

But if Warren Buffett is correct—and we are getting closer and closer to a real bottom—now is not the time to be watching from the sidelines.

Instead, you should be wading in one step at a time using dollar cost averaging as your guide.

Unless, of course, you think we are headed for the next Great Depression. Then you ought to be buying rice and beans for your bunker.

As for me, I’m not much for bunkers. I’m content to be buying blue chips at a discount.

What can I say?

I love a sale as much as Buffett does.

Your bargain-hunting analyst,

 steve sig

Steve Christ, Investment Director

The Wealth Advisory

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