The Costs and Risks of Dollar Cost Averaging

October 19th, 2012
in contributors

Online Trading Academy Article of the Week

To Average or Not to Average?

by Brandon Wendell, Instructor, CMT, Online Trading Academy

Anyone who has had a retail brokerage account is likely familiar with the term “dollar cost averaging.” The original definition of dollar cost averaging, dollar_sign_chrome-SMALLor DCA, is “a regular investment of equal amounts at regular periods of time.” It would be as if you bought $1,000 worth of shares of a security every month for a year or more. Due to market fluctuations, you would sometimes be able to buy more shares when the price was down and less shares if the price rose. After a period of time you may be able to have a better starting point for your investments than if you had invested a lump sum all at once. The theory is that you as an individual cannot time the market and rather than risking your capital by buying at the top of the move, an average is better.

Follow up:

While this may work in theory, in real life as traders we know this is not the case. Brokers caught onto the DCA as a way to increase their commissions and appease clients who may be facing losses. The broker would sell stock to a customer that they believed was a good investment or perhaps something the brokerage had put on a recommendation list. For example, the shares could have been purchased for $20 a share. If the price dropped to $18 a share, the broker could call the customer and tell them to purchase more. Buying more shares at $18 would drop the average cost of the investment to $19 a share. The broker would remind the customer that they would actually profit when the price returned to $20 instead of just breaking even. If the price continued to drop, the broker may try to convince the customer to buy more. After all, if the customer liked it at $20 and $19, then it is a steal at $16. Heck it is on sale right? In a perfect world, the stock would return to at least $20 or higher so that the investor would profit and the broker would look good. But what if this strategy was applied to a stock in the beginning of 2008, or 2000, or any market bubble? How long will the customer want to add to a losing position or hold onto it?

There is also the opportunity cost associated with DCA. Opportunity cost is the cost of doing something while sacrificing doing something else. While an investor is holding a failing investment or adding more to it, their capital could have been applied toward an investment that was moving in their favor. They have lost valuable time and perhaps money by sitting on a bad investment. I bring this topic up as the markets are reaching towards the highs established before the credit bubble crash. Some of my students were curious if their investments would have “come back” if they were patient. The problem is that even though the indexes are reaching back to their previous highs, not all stocks are participating and there are no guarantees that the stocks you owned would ever regain their value.

Looking at the indexes, they are not even the same. The companies that are responsible for for calculating the indexes change the stocks that make up the indexes. On a regular basis, they will remove stocks that are underperforming and dragging down the performance of the index and replace them with better performers that they believe will increase the index. We as investors or traders should look to these companies as a role model. Rather than wasting time trying to salvage a loser, we need to dump them and focus on profitable securities. As traders we have limited time to profit from our decisions. We are looking for the best rate of return, with limited risk, in the smallest time possible. Instead of averaging losses, why shouldn’t we add to winning positions? We know we were correct in the direction for the security, we should be able to increase our profits in that winner.

We do not need to look far to see where DCA can cause catastrophic financial results. I write this article just before JP Morgan releases their quarterly earnings. The major news surrounding this company is of course the $6 billion loss that resulted from bad investments from their London branch. That loss was originally thought to be $2 Billion but with further examination, it was found to be much larger. The loss occurred in the past quarter and may not have as much of an impact as it had in the last earnings report. However it has been reported in the NYTimes that the bank doubled their losing position between 2011 to 2012 to nearly $150 Billion in an effort to cost average and get out of a bad position. They could have controlled the damage much better by exiting the bad positions.

We can learn much from the professionals in the markets. Both through good examples and also dire warnings. The market turns can be timed. At Online Trading Academy, we teach our students proper market timing techniques through rule based trading. What we do not teach is an outdated strategy that can put student’s capital at great risk.

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About the Author

Brandon-WendellBrandon Wendell has appeared as a guest on CNBC, Bloomberg TV, and Fox Business Channel. He has conducted special seminars for CNBC staff on technical analysis of the financial markets. Brandon has published articles in The Trader’s Journal, Forex Journal, Investor Magazine, and Investor’s Business Daily. Brandon has also appeared as an industry expert speaker at the Trader’s Expo, The Money Show, and Asia Traders and Investors Conference.

As a former stockbroker, brokerage trader, and hedge fund trader, Brandon brings various market views and insight to his trading classes and lectures. A wealth of knowledge, he has held NASD securities series 7 and 63 licenses. An Online Trading Academy graduate himself in 1998, Brandon has been trading equities, options, forex, and futures in his own account since. Brandon taught for Online Trading Academy in 1999 to 2001 before becoming a Realtor and commercial mortgage broker and also managing a venture capital firm. Returning to the Online Trading Academy family late in 2005, he now balances trading, teaching and a real estate career. Brandon is also the San Diego Chapter Chair of the Market Technicians Association and holds the Chartered Market Technician Designation.

The July 2010 cover of Traders Journal featured an interview with Brandon in which he shares some insights, hard learned lessons, recommendations and advice. You can read it here: Interview: with Trader Brandon Wendell.

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