Investing, Money Management | Dollar Cost Averaging: Bet Small, Bet Often

In my recent post on dollar cost averaging I said that I think of this investment purchasing strategy as “mak[ing] a lot of small bets.” What I meant by that is that through dollar cost averaging you mitigate your timing risks by entering the market at many points in the hope that more of your entry points will generate good outcomes than bad ones.

We also learned last time that dollar cost averaging is a stock buying strategy designed to protect us against making the worst timing decision at the cost of being unable to make the best timing decision. The protection is achieved by making smaller but more prolific purchases to reduce the impact of poor timing on any particular purchase from affecting your overall return. When first reading about dollar cost averaging I got this feeling in my stomach that I had heard something like this before. I couldn’t quite put my finger on it until suddenly it burst into my head like an extremely over sized pitcher of childhood sugar water goodness . It brought to mind two words: Oh yeah! Vegas, baby!

Managing Risk Vegas Style

Dollar cost averaging is very similar to various betting strategies for many different casino games. Each round of stock purchasing is like a hand being dealt, dice being tossed, or a wheel being spun. Unlike Vegas, however, these rounds can last for as long as you are willing to hold onto your stock or mutual fund. To illustrate this, take a look at the chart I generated for the basics of dollar cost averaging post with the outcome of each particular bet (stock purchase):

By generating a larger number of good outcomes, Peggy Sue was able to turn a nice profit despite the overall decline of the value of the stock over the two year period of dollar cost averaging. At each stock purchase point, Peggy Sue is betting that over a long period of time that the value of the stock that she purchased will rise. In other words, she is wagering that she bought in at a favorable entry point for the stock. Betting in casino style games assumes the same general principle. At each particular deal, spin, or throw the bettor is wagering that they are entering the betting ‘market’ at a point when Fortuna will send them a nice little chunk of change from the hands of the poor through the hands of the criminal and über corrupt. If Fortuna is smiling a lot in the gambler’s general direction then they will win more then they lose and walk home a winner, just like Peggy Sue did in the farcical aquatic ceremony she participated in last night (and in the hypothetical dollar cost averaging example above). See, casino gambling and stock purchasing are the same thing.

The relation between gambling and the stock market doesn’t just involve spreading out risk and seeking favorable entry points. Being a successful gambler (and investor) requires knowledge, discipline, and commitment.

Knowledge - In the game of Black Jack the best way to increase your odds of good outcomes is to have knowledge in the game that you are playing. If you are a Black Jack player then you need to know the basic decision making chart. This becomes the basis for all every hand of Black Jack you play. In the same way, investing requires you to have the ability to analyze stocks based upon their financials and market conditions. Once you know how to do that, you do it with every stock that you purchase.
Discipline - Having the knowledge will only take you so far if you don’t have the discipline to implement it every time. The chance for success is so small in the game of Black Jack (the house has a about a 1% advantage over you) that if you stray from the methods that give you the best chance of success you are going to get burned way more often than not. Sticking with investing strategies that rely on companies sound financial outlooks, quality products, and good management as well as sticking to the correct strategy for the market conditions is the only way to pick more winners than losers on Wall Street.
Commitment - Both Black Jack and investing have their ups and downs. Having the steely resolve to hang through the tough spots or to lock in your profits in highly volatile stocks is the key to long term and repeated success. You cannot let the short term cloud your judgment.

As you can see, gambling and investing in the stock market are similar. Lest anyone conclude from this article that gambling and the investing are the same, here are some ways that these two enterprises differ dramatically:

• When you invest you are becoming the owner of a company whereas when you gamble you are buying entertainment and chance to win more money.
• When you invest you are fairly safe from losing your whole investment whereas with gambling you lose everything around 50% of the time.
• When you invest you are putting confidence in the products or services of others whereas when you gamble you are putting your confidence in probability and chance.
• When you invest you support a companies employees and provide products and services to the world whereas when you gamble (and lose) you enrich the rich and encourage them to get others to act just like you

Conclusion

Dollar cost averaging is a sound investment purchasing strategy that helps an individual minimize timing risks. The principles that make this strategy effective are also found in other fields where risk is plentiful (read gambling, surgery, dating, etc.). While this similarity allows for easy comparison between gambling and investing it is important that we don’t start thinking that gambling and investing are exactly the same. They are not. Don’t make that mistake.

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Categories: Investing, Money Management ~ Tags: investing strategies, risk ~ Trackback