If you haven’t been living in a hole for the past few weeks then you have probably seen what has been happening to the stock market. It has been falling deeply into oblivion, wiping out trillions from retirement systems and equity accounts nation (and world) wide. Since the beginning of the year, the Dow Jones Industrial, Nasdaq Composite, and S&P 500 have all suffered losses in excess of 35%, with especially heavy losses occurring at the beginning of this month (Oct 2008). With such steep losses affecting our investments, is this the time to dollar cost average into the declining market to capitalize on its future growth?
Before I get into answering this question about dollar cost averaging I feel like I need to make a little disclaimer about myself: I am not an investment guru. I have a grand total of $0.00 in any self directed online investment portfolio and don’t see myself investing any money for at least a couple years. I would that it would be different, but my current financial situation has kind of excluded me from this type of wealth building activity.
Now I do have a 401(k) with an employer match, but my contribution is so piddly that it doesn’t really amount to anything. I mostly do it for the employer match – which is 50% – since that pretty much destroys any rate of return I could get by putting that money into a savings account. I wish I could get even more from my employer in this way, but I actually have to use that money to eat and stuff.
But enough about me and my total lack of any authority on investing topics and back to this issue of dollar cost averaging in a declining market.
In case you have gotten this far and don’t know what dollar cost averaging is, it is an investment strategy that attempts to minimize the timing risks associated with investing a lump sum of money by spreading that risk over many smaller investments over a given period of time. The idea is that by betting small and betting often dollar cost averaging will lock an investor into some favorable timing conditions, such as when prices are at a cyclical low. That way, when the price of the stock eventually goes up1 you will be poised to take advantage of the fact that some of your buying occurred at cyclical low points.
If this still isn’t making sense, check out my post on the basics of dollar cost averaging for a much more detailed explanation and pretty pictures.
Dollar Cost Averaging When The Market Looks Bad
I think that the real question that I am asking about dollar cost averaging is this, “Is DCA a good way to mitigate risk during a declining market?” I think the answer to this question is a resounding NO!
There are two main reasons that I think this way. The first is this: I don’t think pumping money into a declining market over time is a good way to mitigate your timing risks because the market is declining. The chances are that all your bets are going to be bad at this point in time. You only really suffer timing risks when markets are trading in a relatively lateral fashion or when a massive drop in the market occurs unexpectedly, not when they are on a steady decline. A series of pictures might be useful here to help us better understand what I mean.
The above graph in an example of when the market traded within a certain band over a given period of time. The specific stock in question is Coca Cola (COKE) and is historical data from 2001. As you can see there was little overall change in the price of the stock from the beginning of the year to the end of it (a total change of $0.02 from the opening price on 1/2/2001 to its closing price on 12/31/01). For the sake of this example I will compare investing $12,000 with the lump sum investing strategy with what the outcome would be if I dollar cost averaged that $12,000 in $1,000 increments on the first day of every month.
If I invested all my money at the beginning of the time period represented in the above graph then I would have ended up $6.34 (0.05%) ahead after 1 year. If I had dollar cost averaged into the market at this time, then I would have ended down $272.53 (-2.27%) over the exact same period of time. The reason for this difference is that with each purchase of stocks using DCA locked in at a different price. Some of the stock purchases would have been at a better price than my first one while others might have been worse than the first because of the cyclical nature of this trading cycle. By increasing the number of bets (trades) made, dollar cost averaging attempted to spread my risk over many different purchases. Instead of helping improve my returns, though, it actually ended up hurting me.
In this particular lateral market conditions dollar cost averaging appears to provide a sub optimal return on investment. I should have put all my money in at the beginning. This isn’t that case in all circumstances, as the example in my original post about dollar cost averaging pointed out. But in this case, DCA loses pretty badly to lump sum investing.
Now that we have seen how this investing strategy works in a lateral market, what about dollar cost averaging in a declining market?
This is a graph of the S&P 500 over the past year. If this does not represent a declining market, I don’t know what does. If I had invested a lump sum of money, lets say $12,000, at the beginning of this decline into a lost cost index fund that tried to mimic the returns of the S&P 500, I would have suffered a loss of $4,724.40 (-39.37%) – and assumes an expense ratio of 0%. If I had dollar cost averaged in this market I would have lost less than that, but I still would have lost $4019.11 (-33.49%) if I had invested $1,000 on the first trading day of every month. If I had held onto my money and kept it in a low yielding savings account it would have grown by $18. 2 It is pretty rare when a savings account will beat returns in the stock market, but a serious decline like this is one of those instances.
Dollar cost averaging money into a market like this will only result in one outcome – poor returns.
Do Not Dollar Cost Average Into A Declining Market
Before, I mentioned that there were two reasons that I though dollar cost averaging into a declining market was a bad idea. The first was that it doesn’t make sense to make bets (trades) that you know are going to be bad (because the stock market will continue to fall). If you think the market (or a specific stock) has farther to fall you are best served by keeping your money out of buying new stocks all together. Why lock in at a price that you think will continue to drop? It just doesn’t make any sense and was the point that I made above with all those pretty graphs and stunningly awesome commentary.
The second reason is very much like the first, but slightly different: why invest money in a stock market that you think you will lose value over the course of the next couple months when you can get sure money by putting it into a high yield savings account? You should go with the sure-thing money all the way because you saddle yourself with losses when you buy into something that you think has yet to reach its bottom. Why not save the money until you are certain that the decline has stopped?
This makes much more sense to me. My solution to the current conditions would be to stop any scheduled stock purchasing plan that buys stocks on set time intervals (like dollar cost averaging) and instead sock that money away into a high yielding savings account until you think that the market has hit bottom, leveled out, or started rising again. I’d bet you $10 if we met in person that the return would be better on your money than if you continued to dollar cost average while the market is in decline.
- This is the fundamental assumption of all investing strategies other than short selling, so if you find fault with Dollar Cost Averaging here you have to find fault with practically every other investment strategy as well [↩]
- Savings account information is the current annual percentage yield on the WaMu, now Chase, brick and mortar savings account. It is 0.15%. [↩]
Wow. This is the worst analysis of cost averaging I’ve ever seen. Clearly the whole point of it eludes you. So when exactly should I throw my large sum of money into the market? Two months from now… three? Being the financial genius that you are, can you just shake your crystal ball and tell me when the market will bottom out. Oh yeah, no one knows. This is why we cost average!
@ Matt – It is good to hear a dissenting opinion, even if it is from someone who offers nothing positive to the conversation.
You make an ad hominem attack, which has no merit in reasoned discourse and makes no sense whatsoever.
Let me address what I can guess is your objection to my thoughts on this since it wasn’t positively stated – guessing when the market will bottom out is bad and too risky so you should keep pumping cash into the market as it declines in case it rebounds very quickly, dollar cost average ftw!
To answer this objection I would respond with the following – you don’t have to guess too well to do better than dollar cost averaging. This is pretty common knowledge among academic investors who are very critical of dollar cost averaging as a whole. By and large, dollar cost averaging returns inferior returns than lump sum investing, just check out this article:
http://www.moneychimp.com/features/dollar_cost.htm
But back to your “perfect timing” objections. I was suggesting that it seems wisest to me to maybe be a little cautious during these times and maybe wait until you have signals from the market that things are stable again. This could take months to see. During the interim, selective buying is a good idea (in my opinion) and would enable you to pick up sweet deals on stocks that are being battered for no reason. But it seems wisest to me to avoid broad based buying in the form of index investing because I think the market may have farther to fall.
This is my main assumption and I could be wrong. You might not make the same assumption. Or you might, but are unwilling to change your investing habits based upon your own assumptions. I recommend that you look at the numbers and see if my thoughts make real-life, practical sense. If they don’t, feel free to tell my why so I can rethink things and become better for it. You will be helping me, and people who read what I say, out.
If you’re investing for the long term, why wait until things are stable again? The only risk is that you’ll invest too soon, and that things will go down more, and that you could have possibly gotten the stock for cheaper. If you’re investing long term, you want to be buying when stocks are on sale, which is what a down market is.
What I’m saying is that I don’t understand your reasoning, but I believe the problem is that you’re showing this in too short of a timeframe. Personally, I wouldn’t care what my investment is worth at the end of the year – I’m looking to see what it’s worth in 30 or 40 years.
@ Stephanie – Thanks for the comment, it has helped me think about this a little more and that is always good!
I guess what I was thinking was this – that investing now is good if you pick up specific stocks that are slamming deals but not if you decide just to buy because it is Tuesday, or the fifteenth of the month.
It is my understanding that dollar cost averaging locks a person into buying stocks (but mostly mutual funds of one variety or the other) in this fashion, and for this reason it seems like sub-optimal investing during our topsy turvy downward moving market. Madame X over at My Open wallet lamented something similar in discussing frustration over stock market gains at just the wrong time. While this is isn’t as big of a deal in a lateral moving market (IMO) it is bad in a downward moving one because no matter what price you buy it it will probably be sub-optimal.
Also, as to your point about being concerned with the long term, I think I view the long term as many different short terms added together. If I hamstring my efforts to capitalize on the bargains that do exist by investing broadly into an index or mutual fund with dollar cost averaging while a market is in decline I will be hurting my returns in 30-40 years. Wise short-term investing now will reap benefits in the long term.
Taking losses for no good reason can be devastating to a portfolio over the long term. Brip Blap did a good job of discussing this in a post about how long it will take his index fund portfolio to recover from recent losses.
But, if you think we have hit bottom then I would think that dollar cost averaging might be a good idea. Since I don’t think we have yet (just a hunch, no real information on this one), it seems best to avoid unnecessary loses.
Hmmm… I guess I’m still not getting what you’re saying.
If I thought stocks had hit bottom, wouldn’t I be better off lump-sum investing, rather than DCA? If they’ve truly hit bottom, then this would be the cheapest I could get them, so I should buy as many as possible right now, to get the best deal.
But if they haven’t hit bottom, I don’t want to lump sum invest, because I might be able to get them later, at a cheaper price. So DCA works in my favor, because I buy some now, and if I’m right about it going lower, I buy some later for even cheaper. If I’m wrong about it going lower, I’m still good because I bought some while it was at rock bottom, and got a good deal then.
But if this is rock bottom, and I put my money into a savings account instead, then I’m missing out on the big sale.
I always thought DCA had it’s disadvantages in an up-market. That is, you’re buying the same thing over and over again (a mutual fund, stock, or index fund), but at an iincreasing price each time. It’s like going to the store and buying canned tuna every week, but every week the price goes up. At the end of a year, you have 52 cans of tuna that are all exactly the same, but the first one was far cheaper than the last one. You would have been better off buying them all at the start of the year, when they were cheap.
On the flip side, if you’re buying tuna that keeps going down in price every week, you’re happy. Each week you buy another can, because you don’t know when this crazy sale will end and the price will start to go back up, but you’re getting your tuna cheaper each week. Now, lump-sum would be buying a ton of tuna when you thought the price couldn’t go any lower. That’s smart – if you can tell exactly when that week is. And of course, the supermarket won’t tell you!
Sorry if my tuna analogy got out of hand here!
@ Stephanie – I think the tuna analogy is a great one! But before I get into that, let me go about this in an orderly fashion.
First off, I think you are right in saying that lump sum investing is better than DCA when it comes to upward trending markets. This makes sense because with lump sum investing you are locking your buy in at a really low price as the market rises. Dollar cost averaging doesn’t benefit from this because it spreads its purchases out over time and will probably buy in at higher prices than the lump sum investor would.
We are in total agreement here, I think.
I think what I was trying to do in my post and in my comments is to show a similar sub-optimal relationship between dollar cost averaging in a declining market. Here is where I tried (but obviously not well enough to be clear or convincing) to show this:
The similarity between the terribly performing lump sum investing and dollar cost averaging in this example gives me pause in considering DCA as a valid bargain buying opportunity, especially if it is done through index investing.
Obviously hindsight is 20/20, so I’m not saying that we should never DCA – it’s just that if we think things might have farther to fall it seems like a good idea not to DCA so that we can be better poised to take advantage of an expected “return to normal.”
Now to your brilliant tuna example. It think that this is a very useful way to think about this and found it very helpful to me, so thank you very much for offering it. When I think about the way that most people Dollar Cost Average I think that they do so into a mutual or index fund. A paycheck comes and whamo – buy some additional shares in the index fund (since they are a long term investor).
To me this DCA index investing is more like buying 500 products at the grocery store than it is like only buying cans of tuna. Sure you will buy some cans of tuna that are on sale when your paycheck comes, but you are also going to be buying cereal, Gatorade, french toast sticks (*drool*), maybe a romance novel, a Slim Jim (for the protein, of course), etc. While tuna might be a slammin’ deal right now all the other stuff that you just bought is really over priced. The supermarket’s loss leader did its work, getting you to buy expensive things when all you wanted was the rippin’ deal on tuna.
By all means buy the tuna while it is on sale, even if the price will continue to go down on its already low, low price. I just think that buying the cereal et al. should be avoided if you think that they are over priced right now.
Does that make my position a little better presented or am I still a babbling, incoherent madman?
[...] presents Dollar Cost Averaging In A Declining Stock Market posted at My Family’s Money, saying, “This article argues that dollar cost averaging [...]
[...] thinking about dollar cost averaging as an investment strategy a bit these days. My last post about Dollar Cost Averaging In A Declining Market and the discussion in the comments has really helped me get my thoughts together and crystallize [...]
How about dollar cost averaging in a range bound fund such as the Pimco Total Return Bond Fund.
http://finance.yahoo.com/echarts?s=PTTRX
I think Stewart your strategy of investing lumpsum everytime the fund hits $10 might be give a better return than DCA.
what are your thoughts. This fund seems to be gyrating between its ranges depending on interest rates over a long long period of time
Hi Paul,
I am not a financial planner or investment professional of any sort, so you will need to take what I have to say for what it is worth.
There are a lot of different things you want to take into consideration when buying anything in the stock market, but the thing you want to think about the most is value. I would always recommend investing when you think there is value to be had so if you think that this bond fund only has value once it hits a certain price then I would say that you should only buy it once it hits that range.
That is certainly the philosophy that I think is right, but I honestly don’t have very many tools to determine when something is a “value” or not. I am currently seeking to get educated on that topic, but as of today I would have to honestly answer that I don’t know how to determine value on the stock market.
So your guess is a good as mine as to whether or not the Pimco Total Return Bond Fund is worth dollar cost averaging into or holding off and investing a lump sum once it hits a certain price point.