Saturday, May 16, 2009

Dollar Cost Averaging is Stupid?

It is funny that some people actually say that the “dollar cost averaging technique” (also known as DCA) is a stupid method. They start “giving up” using this technique especially when they make a lost in investing in Unit Trust or Mutual Funds.

“Dollar cost averaging is stupid! It doesn’t work and so far I have made a lost -30% out of my unit trust investment. What the heck? I should buy low and sell high, that’s the perfect technique!”
I used to heard of this kind of statement and RECENTLY getting more and more due to fact that the recent economy recession caused by the subprime crisis that most unit trust or mutual fund make a lost around -20% to -30%. More and more people start complaining about this “Dollar Cost Averaging” method is stupid and they regret to follow this technique which they used to believe that it is 100% guaranteed method as told by their agents. 100% guaranteed? Who told you that?


Dollar cost averaging is not stupid, okay?

Technically dollar cost averaging is NOT stupid but it was designed for STUPID people if you insist me to use the “stupid” word. So if you think you’re not stupid – know exactly when to sell high and buy low, don’t use Dollar Cost Averaging method. If you do, then you’re really stupid because Dollar Cost Averaging method is not designed to be used this way especially when you know when to sell high and buy low. So, do you think you're stupid or not?


What is the purpose of dollar cost averaging?

Dollar cost averaging is designed to be used by stupid people who doesn’t know exactly when to sell high and buy low. Also, this technique is designed for Long Term Investment Strategy – 5 to 7 years for example. If you’re using this method as a short-term investment strategy, then you use it for the wrong purpose. So now the question is - do you know when to sell high and buy low? Do you know the market goes up or down tomorrow? If you don’t know, use dollar cost averaging. But, would DCA guarantee Return of Investment (ROI)?


How dollar cost averaging works?

It is a very simple technique that you just need to invest fixed amount of money periodically (usually monthly). You can apply this whether to stock or unit trust or any kind of investment. This technique basically forces you to:
  • Buy MORE units investment at lower prices
  • Buy LESSER units investment at higher prices.
This is in a way to reduce your risk during market downtrend. When market goes down you buy even more units. As long as the market goes up again in the future, you will earn. But of course if the market never goes up, you will keep losing and that’s the whole point the dollar cost averaging is for long term investment strategy which you believe the market will go up in long run.


When you want to use dollar cost averaging?

Obviously, when you think you’re stupid you use this method. Because of this method is designed for stupid people like you and me, therefore once you’re start using this method, you’re not considered as stupid anymore – you’re smart!

Here you go the reasons when you should use DCA:
  • Don’t know when to sell high and when to buy low. You can use one lump sum investment strategy if you know exactly the lowest and the highest of the market
  • Only if you BELIEVE your investment will goes up in long term - 5 to 7 years or even more years. If you intent to use DCA for short term investment, let’s forget about it
  • Continue to use DCA even during market downtrend. Don't stop or complain about DCA method when you make a lost in investment. DCA is designed for you to even to invest more (buy more units) during market downtrend. Unless, you're kind of sure that the market will never be recovered again, you can give up DCA method then.

Summary

Dollar cost averaging is in fact a perfect method to guarantee the investment return as long as the market or stock or unit trust that you buy goes up in long run. Most importantly it reduces the risk when the market goes down and you can earn back your investment when the market goes up again. 

How can this perfect method being perceived as a stupid? Don’t fall into the common trap that does not understand the purpose of DCA method. Use a right method for a right purpose is SMART, use a right method for a wrong purpose is STUPID. Don't you think so?

In personal finance, as long as we do it right we can be as stupid as possible. That's is something FUN about personal finance. Have fun!

23 Comments:

SEO Log said...

i still doing cost averaging for my UT investment

ChampDog said...

Ya, that's good news. You may want to consider to invest more than your regular fixed amount during this downturn.

imDavidLee said...

good post..im not using dollar cost averagingbut ringgit cost averaging...

i used this technique mostly when economic downturn or my actual price for that unit is quite high, then use it to lower down my price/unit

ChampDog said...

Hahaha... RCA == DCA, American term versus Malaysian term. :)

Sometimes when we know the timing, we don't need to 100% follow the DCA method. So, you can mixed around this DCA method with one lump sum investment.

For example, you can put more money during economy downturn or sell out all your investment before this economy downturn then invest back later on at lower price.

Kris said...

I think most people don't really understand the term : LONG TERM Investment..LOL. That the magic condition why dollar averaging works!!

ChampDog said...

Yes, it is for long term. We all love short term gain, I do too...

Having said so, just for the sake of discussion - one of weakness of DCA some people challenge it is, DCA often tend to ignore the transaction fees which could be a large amount especially if you invest periodically. :)

Alvin Lim said...

DCA is good only if u know what you are buying. For UT is still okay since the professionals are handling it for u, but when it comes to stock, it is best to know what u are getting urselves into. the last thing u want is to doing DCA for a company which is going to die soon. ur losses might end up many times more than before the DCA.

ChampDog said...

I think you have a point. You need know exactly what you buy when it comes to stock especially.

But let's say the investment strategy is long term and you have done some homework that you believe in long term this company will outperform, I think you still can use the DCA method without really care much about the timing.

That's the purpose of DCA.

HSO said...

I have a few points to add on:

i) It is not 100% fool proof method if dollar cost averaging is used blindly. Like what Alvin Lim mentioned, this is especially risky if we used it wrongly on the wrong equity/stocks. At the worst case, it could be like throwing money into a blackhole! However, if used correctly, it is a great strategy for long term return at moderate risk.

ii) When it comes to mutual fund/unit trust investment, the transaction cost is the same whether you put one lump sum or spread your investment into multiple top-ups over a period of time. Those who claim that dollar cost averaging cost a lot in transaction fees are those who invest directly in individual company stocks. It is true that dollar cost averaging may not be cost effective if we trade individual stocks, unless the amount involve is relatively huge compared to the transaction fee.

iii) There is one important thing missing, if we just implement dollar cost averaging. You only buy fund/stock at regular interval with fixed amount of money over a long period of investment horizon. Think about this, if you are retiring, have no earn salary/income except a lump sum retirement fund in your investment account. The market has gone down a lot, and your equity funds in your portfolio has dropped by 40%, what can you do? Unless you have fresh money, otherwise, you cannot do cost averaging. So, what is the solution? :)

iv) You should also employ asset allocation strategy while doing dollar cost averaging. Be it strategic allocation or tactical allocation, you will benefit from both cost averaging, and controled portfolio risk exposure so that it matches your own investment risk profile. Otherwise, you only have buying strategy, and you have no strategy to lock-in your profits. You may end up in square one after you reach your retirement, and at that time, you have no money and no time to do dollar cost averaging!

ChampDog said...

Think of it, if we invest to the wrong stocks, DCA still helps to reduce the damage. Don’t you think so? I agree with the “long term return at moderate risk” or in fact is moderate return as well.

Thanks for sharing this. So I guess no matter how often you buy for UT, the total of transaction cost is always the same. So we need to be little careful if we use DCA for stocks. Good sharing!

Solution when we run out of cash in DCA strategy? Hmm… Shall we still invest after we retired? Even if we do, won’t this better if we invest in lower risk investment (FD or Bond)? Can this be considered as a solution?

Yes, I think the both asset allocation strategy and DCA have the same goal which is to reduce the risk but gain with the moderate return.

Yow Chuan said...

Yes, I would agree with Alvin on the appropriateness when applying DCA.

When you're in the battleground yourself, you have to focus on many things; the wind, the humidity, the noise level; booby traps, landmines. So many things to take into consideration, and the most important factor is your probability of surviving the mission. Sometimes, the safest way is to cut loss entirely and reboot the mission because of the unfavourable terrain or weather. The longer you hold on to the unfavourable situation, the thinner your chance of survival.

Whereas if you have a coach guiding you around (fund managers), you can at least have a little breather that the terrains has somewhat been scouted by them using some 'advanced technology'. In this sense, all you probably need to focus is that you have enough stamina and bullets to last you through the mission. It will still be challenging, but you've paid some 'fees' to clear out some of the 'unknown factors' in the mission.

Haha...sorry for the long winded story, but I just love the analogy between a jungle commando and an investor.

imDavidLee said...

i believe that buy more unit during lower price bring more profit in future

ChampDog said...

@Yow Chuan
I can see that you're a very creative person and I really love your analogy. It is really a good one especially the following statement:

"Sometimes, the safest way is to cut loss entirely and reboot the mission"

So, I guess we need to make sure which best work for us whether by our won OR have coach guiding us around. What best for you I wonder?

@imDavidLee
I guess you're buying more units now? :)

Source Blogger said...

Dollar Cost Averaging strips the investor from his/her duty to understand the mechanics of the market. Besides what stock are you buying - and why are you buying it - when to buy it is just as crucial a component. It's very easy to be in the "right stock" at the wrong time. I'm not advising everyone to be a chart/technicals guru, but you should be comfortable with looking at a chart and looking at things like trading envelopes, bollinger bands, and 20/50/200 moving averages. Sometimes it's best just to not do anything and wait for a stck to pull back into an acceptable entry point. And always, always use limit orders! No scheduled/timed purchases!

ChampDog said...

I'm just thinking we we're not the technical guru, how could we really make sure we can buy the "right stock" at the "right time"? Any thoughts?

gerbert said...

hi.. i'm new to your blog. good info you are sharing. keep on the good job.

ChampDog said...

Thanks, Gerbert. :)

Kris said...

It is stupid if you don't follow through your plan of averaging when the market turns southward.. :P

ChampDog said...

Hahaha... you have a point! :) and I totally agree with that.

Anonymous said...

Hi.. can i just ask a stupid question.. cuz i'm not really familiar with this.. when do you sell the stocks when u are conductind DCA? for example if u aim to conduct it over a 5 yr horizon, then u sell ur stocks at the end of 5 years? or do u sell anytime u feel that u have made a profit?

ChampDog said...

Good question indeed! :) Ultimately, you want to sell it with profit of course.

The most straight forward way is you can calculate the total profit and % investment return as the following formulas:

Total Profit = Total Return - Total Investments

% Investment Return
= (Total Profit)/(Total Investments)

So you at least need to keep track of how many $ you have invested in order to know your profits. Hope this helps.

Anonymous said...

but what happens if you plan for a 5 year horizon, then in 2 years, you realise that u have made a profit, so u sell the stocks.. then do u continue investing in the same stocks for the rest of the 3 years or do u change ur investment plan?

ChampDog said...

The short answer is “It is really up to you.” :) Anyway, I try to answer the questions that you have and see if that makes sense to you.

If I were you, let's say after 2 year and somehow I know the investment return is the most Optimum (for example, I'm sure or I predict the third year will drop), I will sell it and reinvest it at lower price.

Another reason you want to sell is you want to switch your investment plan (technically they call it your personal investment portfolio). Investing in stock is generally riskier than mutual fund. For example, you used to invest 60% of your investments in stocks and 40% in mutual funds. Now, you don't want to take more risk and you decide 40% in stock and 60% in mutual funds instead, then you basically can sell your current stock and move the 20% to mutual funds. This is called “asset allocation”.

In short, if you continue to invest the same stocks with the same amount of return that you get in 2 years, there is no reasons you want to sell it. This is with the exception that you know the highest point and you reinvest at the lowest point. Also if you plan to change your investment plan or your personal investment portfolio (e.g. take less risk), you can sell part or all of it depending on your investment strategy.

Generally, when you're young you can take more risk because you have less dependents (people who financially depends on you) and most importantly you have the ability to earn back the $ that you lost. However, when you get older, you usually switch your investment strategy to lower risk investments.

I'm not sure if I answer your questions but keep in mind the DCA is for long term investment and it only works if your investments have high return in long run. For example, you apply DCA on a stock that has never gone up, you will still be losing money.

Hope it helps and let me know if you have further things to discuss. :)


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