Investing–The New Rules: Dollar-Cost Averaging is a Loser

Why Dollar-Cost Averaging is a Losing Strategy

Why is Dollar-Cost Averaging a losing proposition? Rob Bennet knows: convoluted strategies will not turn a bad value proposition good. Dollar-Cost Averaging is a trick. Today, he explains why.

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Investing — The New Rules
Dollar-Cost Averaging Is a Loser Strategy

#7–June 14, 2010

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I was eating a chocolate donut after church when my friend Kevin came up to me to ask me about investing. This was in late 2008 when the Dow was falling several hundred points per week. He had heard that I wrote about investing and wondered if I could offer any special perspective.

You know what I told him. “The realities are easy to understand intellectually but sometimes hard to accept emotionally, Kevin,” I said. “If you buy stocks at good prices, you will always do well in the long run. If you buy stocks at bad prices, you will always do poorly in the long run. It’s been that way since the first stock market opened for business and it is not possible for the rational human mind to imagine how it could ever change. You need to look at the valuation level that applies for stocks before buying them. That’s the secret.”

“That makes sense.” Kevin said. “I think I read about that somewhere. It’s called Dollar-Cost Averaging, right?”

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Yak!

No! No! A thousand times no! Dollar-Cost Averaging is a terrible idea. Dollar-Cost Averaging is what you want to avoid. Please don’t ever quote me as having said that Dollar-Cost Averaging is a good idea. Dollar-Cost Averaging is a loser strategy.

This sort of thing drives me crazy. It’s not Kevin’s fault or the fault of the millions of middle-class people who turn to stock salesmen for help in learning how to invest effectively. Most of us are busy and don’t have time to scrutinize every statement made by the experts. It’s important to understand that the thing that the “experts” are expert at is selling stocks. They are like politicians in their fondness for slippery language. If you don’t parse every word, they will mislead you to their benefit every time.

Say that it was your job to persuade people to buy stocks and lots of them. Say that the price for stocks had risen to a level where stocks offered a poor long-term value proposition, where investing in stocks was going to set the retirements of the people listening to your “advice” back by many years. What strategy would you suggest in those circumstances to people concerned about overpaying for stocks?

It would probably be something similar to Dollar-Cost Averaging. This is a strategy that benefits the salesmen, not their customers.

If you don’t look at the Dollar-Cost-Averaging strategy too closely, it appears as though it might offer a means of avoiding overpaying for stocks. Those who follow a Dollar-Cost-Averaging strategy are buying stocks at all sorts of different prices. The salesmen will try to put the idea in your head that buying at a mix of prices assures you that on an overall basis you will be paying a reasonable price.

No. It doesn’t work like that.

Stock prices don’t move from “good” to “fair” to “poor” over the course of a few months or a few years. It takes years for investor irrationality to become a sufficiently strong force to push stock prices to dangerous levels. Once that happens, the irrational beliefs that caused the insane prices are widely shared. It takes years of bad returns to persuade the millions of investors who have come to hold such ideas to give them up. Once stocks become a poor buy, ten years or more can pass before it again makes sense to direct your money to them.

That’s what happened during the huge bull market that we are slowly recovering from today. Stocks are fairly priced when the P/E10 value is 14. They remain a good buy up to a P/E10 value of 20. From 20 to 25 is the warning track; there’s some danger in buying stocks at those prices, but it might work out all the same. When the P/E10 value goes above 25, stocks are insanely overpriced. Buying stocks when they are selling at a P/E10 value greater than 25 never works out for the long-term investor. Stay away!

There were only a few months in the entire time-period from January 1996 through September 2008 when stocks were selling at a P/E10 value lower than 25. So how was Dollar-Cost Averaging going to help the investor putting his retirement money into stocks during that time-period?

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ALSO at DBKP:
* Investing–The New Rules: John Bogle’s Evil Twin?
* Investing–The New Rules: Stock Return Predictor Not a Case of ‘Too Good to be True’
* Investing–The New Rules: The Stock Investor’s Weather Report
* Investing–The New Rules: Harness the Power of The Stock Return Predictor
* Investing–The New Rules: Get the Odds on Your Side
* Stock Investing: Much of Today’s Understanding is Primitive

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Yes, you paid different prices for your stocks if you practiced Dollar-Cost Averaging during that time. You bought some shares at a P/E10 level of 25, you bought some shares at a P/E10 value of 30. you bought some shares at a P/E10 value of 35. That’s another way of saying that you bought some shares at insanely high prices, you bought some shares at super-insanely high prices, and you bought some shares at prices that may not be described in mixed company. Dollar-cost averaging did not protect you from the fate always suffered by those who fail to take price into consideration when buying stocks.

The purpose of looking at the price of something is to determine whether it is worth buying or not. Say that there is a car you like. You check Consumer Reports to learn that a fair price for the car is $30,000. You ask a dealer for his price and he says “$90,000.” You flee, right?

But the stock-selling experts don’t want you to flee. They need a way to respond to the customer objection that price must matter when buying stocks without acknowledging that that there are some price levels at which stocks are just not worth the money. Hence — the hundreds of millions of dollars that The Stock-Selling Industry has put behind promotion of The Dollar-Cost Averaging “Strategy.”

When stocks are a bad deal, you need to put your money in other asset classes. End of sentence, end of paragraph, end of chapter, end of story.

Convoluted strategies will not turn a bad value proposition good. Dollar-Cost Averaging is a trick. And tricks are for —

Stock-selling experts!

by Rob Bennett
images:
* Sheer Chaos
* Everything Tastes Great

Rob Bennett recently wrote a Google Knol entitled “Why Buy-and-Hold Investing Can Never Work.” His bio is here. And don’t even think about failing to read these Important Cautionary Words.

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