dollar cost average effect

Good question. I think there are 2 different interpretations, which leads to much of the disagreement. The first usage is for when you have a lump sum, and instead of investing it all at once, you do it in multiple times over a period. The disadvantage is that if the prices grows, then you lose. If the price falls, then you win. The advantage is is that you reduce the risk of volatility (you get an average price over the period).

The other usage is applied to when people invest their income stream as it comes in (like a monthly paycheck), rather than wait for a lump sum to invest. In this case, it is usually better to invest immediately.

This is a question best answered with a spreadsheet, but I'll take a verbal shot:

You are going to make two stock purchases, same stock, a month apart. Of course you don't know the price a month hence. One month it's $20, and $1000 buys you 50 shares. Another month it's $15 and $1000 buys 66.67 shares.

You own 116.67 shares, $2000 cost, average price $17.14.

But, you say, "Joe, the average of $20 and $15 is $17.50." Indeed. If someone has a simpler explanation of the working of Dollar Cost Averaging, I'm listening. In the end, you can run spreadsheets till your eyes glaze over, and find that by starting in 1998 and ending in some

200x year, that the crash would have far less impact and you'd recover far faster through averaging, and in fact, averaging is the way many (I really don't have a % here) invest by saving through their 401(k) at work, $xx/week or month.

JOE JoeTaxpayer.com

Investopedia is your friend ...

... : -)

If you buy a stock many times over a time period you are likely to get closer to the average price than if you buy it just once at the beginning of the period.

Dollar cost averaging is just marketing nonsense to convince people to buy stocks knowing that the price could go down.

Dollar cost averaging is never better if the stock price increases monotonically after the starting period. Dollar cost average IS better if the price of the stock goes down temporarily and then back up. A more effective strategy if you have an inkling that this is going to happen is to buy at the lowest price.

Inflation tends to drive stock prices up even if they are just treading water. The same people who tout dollar cost averaging claim that the stock market goes up 8%, 10% or 12% annually over the long haul. If this is true then a strategy than bets on prices going down is clearly bad. Go ahead, stick dollar cost averaging into your monte carlo simulation with prices going up an average 12% a year and compare it to just buying at the beginning of the period.

Be glad you didn't ask me about rebalancing where you sell some of your winners and buy more losers :)

Happy Investing!

See, this is exactly what I was talking about when I said it depends which definition. You're assuming the example where you start with a lump sum, then delay investing to do DCA.

But I bet if you're talking about your 401K (steady income stream), you would be doing DCA.

"speednxs" wrote

What is nonsense here is your implication that the market never goes down. In fact, it does go down at times, and sometimes significantly.

Studies show that most mutual fund managers (a pretty well-educated group) can't even manage to time the market. The implication that far lesser qualified individuals can get much of an inkling of what stock prices will do in the short run is ridiculous.

No, they claim historically it has gone up at about these rates in the past and on average. These people are not lying, ya know.

This is not a Monte Carlo simulation.

Dollar cost averaging simply grounds an investor in the reality that there is no crystal ball for short term predictions of stock movements.

Nonsense. I assume ten time periods, the stock going from 10 to 19, up $1 per period. I trust that the opposite of "dollar cost average" is "buy equal shares". Buying equal shares, say 100 per month, yield an average buy price of $14.50 (Average of $10.00 & $19.00, no surprise). But if for the ten periods you buy $1000 worth of stock, you buy more at $10, fewer shares at $19, and wind up with 719 shares at $13.91. Any blip off that straight line would only help the cause.

Along the way, turn the $14 month (only) to $25. The equal shares averages $15.60, the dollar average, $14.55.

Or blip the $14 down to $5. Now the equal shares is $13.60, but dollar average is $11.80

You see, the straight growth price is the worst case for averaging, the ups and downs help, but even the monotonic increase bodes better for the averaging (than equal monthly share purchases). No Monte Carlo needed.

JOE

Disclaimer - averaging down to a final price of zero won't help. This isn't about timing nor stock selection. It addresses only the question of the math and result of dollar cost averaging.

Who knows that the price will go down ahead of time? Your definition of nonsense may vary...

There is only one definition of dollar cost averaging. It is a way to diversify your investments by time, as opposed to by market sector, risk, liquidity, and so on.

The benefit is as much psychological as anything else. Use this example: you are going to convert a certain dollar amount of mutual funds from traditional IRA to Roth IRA in the current tax year. You can do it all at once, or do it once per quarter. By doing it all at once you are going to kick yourself if you did it near the peak value for the year, or pat yourself on the back if you did it near the low point for the year -- pretty much all or nothing. By diversifying over four quarters, you are much more likely to feel good about at least a few of your transactions, since at least a few of them are going to be near the low point.

Same psychology applies when you walk into a casino: suppose you have decided you are going to risk losing up to $500. Do you walk in and immediately put the entire $500 down on one number at the roulette table, or do you spread your bets out in smaller amounts over the course of the evening?

Hmm, I just did a little bit of that for the first time in five years, my international mutual fund has done twice as well over that time period than my other funds, so I sold some and bought some of a domestic fund. The reason was, the international fund had become a greater percentage of my portfolio than I intended.

-Mark Bole

"Mark Bole" wrote

This analogy has the strangest appeal... hm... Oh I know why! Because it makes me, an ordinary do-it-yourself, small potatoes, "blue-chips-are-me" investor, right up there with the high rollers in Vegas!

Seriously, I think Mark's analogy above is going to totally seduce any daggang wag who previously did not understand the virtues of dollar-cost averaging. Bravo.

You also would have maximized the income tax due on the conversion. You would rather do the conversion at the lowest price of the year to minimize the taxes, wouldn't you?

Dave

"Elle" wrote in news:ap3eh.7915 $ snipped-for-privacy@newsread4.news.pas.earthlink.net:

Except that it completly misses the mark by comparing investing with gambling.

DCA is an effective way of reducing risk but will reduce the expected return. Said another way it lowers the average return but tends to reduce the impact of some of the bad events.

John

If one assumes that financial markets are close to efficient, dollar cost averaging is an inferior method of investing a lump sum, because one's exposure to the stock market (or whatever asset class is being invested) is distributed unevenly over time. This is discussed in detail in

Mathematical Illusion: Why Dollar-Cost Averaging Does Not Work by John G. Greenhut, Ph.D. at

"John Gunn" wrote Elle wrote

Investing in stocks for the short term (under five years, say) is gambling. Even many newbies seem to understand this.

No, this is not necessarily true. It will depend on market conditions and timeframe.

wrote

To come to this conclusion, one also has to assume a particular timeframe. In response to "When is dollar cost averaging a good strategy?," the correct answer is, "It depends... "

Correct!

Since I don't know when the lowest price will be, I can take several small shots at it instead of one big shot - a form of dollar cost averaging.

It's not a question of minimizing or maximizing taxes -- I'm going to pay the same fixed amount of income tax either way, but the question is how high of a percent of my pre-tax IRA money can I convert to post-tax Roth IRA money?

Incidentally, I don't want to mess with the paperwork involved in multiple re-characterizations of IRA conversions, in case anyone was thinking of that.

-Mark Bole

Dr. Greenhut is not wrong, but he neglects important aspects. He refutes DCA by using percentages needed to correct to the center as opposed to deviations from the center.

Under the heading "Pattern of Price Volatility" paragraphs 1 and 2 , he uses $150 and $75 as his high and low price because they would both take a 33% price movement to reach the $100 original price. Markets don't work that way. Market movements are measured in percent change from a particular price, not how much change would be necessary to get back to that price. I've never heard CNN say "Today's market rose and we will need a 5% decline to get back to yesterday's close. Back to you Pat."

Greenhut's market shows a 25% market loss to purchase at the low (most advantageous for DCA) and a 50% market gain (least advantageous for DCA). Even at that point DCA becomes ONLY AS EFFECTIVE as lump sum, no worse.

Anybody can make the numbers work in their favor if they try hard enough. For ex: you started DCA at a stock price of $1 and it linearly went up to $10 over a week , of course you would have rather lump sum invested at $1, but you had no way of knowing that was going to happen. If the price had linearly fallen by an equal percentage, you would much rather taken DCA. Furthermore, Even if the stock ends the year 100% up that one week would have made a huge difference with DCA.

DCA hedges against the RISK of market downturns, it does not claim to nor will it always result in higher RETURNS. The two are a trade-off. Most of the opponents are arguing scenarios with higher potential returns, but at what risk did you take on those potential returns? Anyone can find a penny stock that may return 10000% but the risk of investment loss may also be 99.99%

You have to decide where your risk tolerance lies. If you think you can time the market (not likely, no offense) lump sum it. If you don't want to take the chance that your investment take a downturn early on, use DCA.

Hi everyone,

That's the way I undertsand it now. It does not mean you will more than the peson who invested only once in that year but you will be better protected when your share have bad days.

I wonder how this worked out in the bear days from 2000 to 2003?

John