Investing

Dollar Cost Averaging In A Declining Stock Market

If you haven’t been living in a hole for the past few weeks then you have probably seen what has been happening to the stock market. It has been falling deeply into oblivion, wiping out trillions from retirement systems and equity accounts nation (and world) wide. Since the beginning of the year, the Dow Jones Industrial, Nasdaq Composite, and S&P 500 have all suffered losses in excess of 35%, with especially heavy losses occurring at the beginning of this month (Oct 2008). With such steep losses affecting our investments, is this the time to dollar cost average into the declining market to capitalize on its future growth?

Before I get into answering this question about dollar cost averaging I feel like I need to make a little disclaimer about myself: I am not an investment guru. I have a grand total of $0.00 in any self directed online investment portfolio and don’t see myself investing any money for at least a couple years. I would that it would be different, but my current financial situation has kind of excluded me from this type of wealth building activity.

Now I do have a 401(k) with an employer match, but my contribution is so piddly that it doesn’t really amount to anything. I mostly do it for the employer match – which is 50% – since that pretty much destroys any rate of return I could get by putting that money into a savings account. I wish I could get even more from my employer in this way, but I actually have to use that money to eat and stuff.

But enough about me and my total lack of any authority on investing topics and back to this issue of dollar cost averaging in a declining market.

In case you have gotten this far and don’t know what dollar cost averaging is, it is an investment strategy that attempts to minimize the timing risks associated with investing a lump sum of money by spreading that risk over many smaller investments over a given period of time. The idea is that by betting small and betting often dollar cost averaging will lock an investor into some favorable timing conditions, such as when prices are at a cyclical low. That way, when the price of the stock eventually goes up1 you will be poised to take advantage of the fact that some of your buying occurred at cyclical low points.

If this still isn’t making sense, check out my post on the basics of dollar cost averaging for a much more detailed explanation and pretty pictures.

Dollar Cost Averaging When The Market Looks Bad

I think that the real question that I am asking about dollar cost averaging is this, “Is DCA a good way to mitigate risk during a declining market?” I think the answer to this question is a resounding NO!

There are two main reasons that I think this way. The first is this: I don’t think pumping money into a declining market over time is a good way to mitigate your timing risks because the market is declining.  The chances are that all your bets are going to be bad at this point in time.  You only really suffer timing risks when markets are trading in a relatively lateral fashion or when a massive drop in the market occurs unexpectedly, not when they are on a steady decline.  A series of pictures might be useful here to help us better understand what I mean.

Dollar Cost Averaging Coca Cola Lateral Trading Example

The above graph in an example of when the market traded within a certain band over a given period of time.   The specific stock in question is Coca Cola (COKE) and is historical data from 2001.  As you can see there was little overall change in the price of the stock from the beginning of the year to the end of it (a total change of $0.02 from the opening price on 1/2/2001 to its closing price on 12/31/01). For the sake of this example I will compare investing $12,000 with the lump sum investing strategy with what the outcome would be if I dollar cost averaged that $12,000 in $1,000 increments on the first day of every month.

If I invested all my money at the beginning of the time period represented in the above graph then I would have ended up $6.34 (0.05%) ahead after 1 year.  If I had dollar cost averaged into the market at this time, then I would have ended down $272.53 (-2.27%) over the exact same period of time.  The reason for this difference is that with each purchase of stocks using DCA locked in at a different price. Some of the stock purchases would have been at a better price than my first one while others might have been worse than the first because of the cyclical nature of this trading cycle. By increasing the number of bets (trades) made, dollar cost averaging attempted to spread my risk over many different purchases.  Instead of helping improve my returns, though, it actually ended up hurting me.

In this particular lateral market conditions dollar cost averaging appears to provide a sub optimal return on investment. I should have put all my money in at the beginning.  This isn’t that case in all circumstances, as the example in my original post about dollar cost averaging pointed out. But in this case, DCA loses pretty badly to lump sum investing.

Now that we have seen how this investing strategy works in a lateral market, what about dollar cost averaging in a declining market?

Dollar Cost Averaging S&P 500 Declining Trading Example

This is a graph of the S&P 500 over the past year.  If this does not represent a declining market, I don’t know what does.  If I had invested a lump sum of money, lets say $12,000, at the beginning of this decline into a lost cost index fund that tried to mimic the returns of the S&P 500, I would have suffered a loss of $4,724.40 (-39.37%) – and assumes an expense ratio of 0%.  If I had dollar cost averaged in this market I would have lost less than that, but I still would have lost $4019.11 (-33.49%) if I had invested $1,000 on the first trading day of every month.  If I had held onto my money and kept it in a low yielding savings account it would have grown by $18. 2  It is pretty rare when a savings account will beat returns in the stock market, but a serious decline like this is one of those instances.

Dollar cost averaging money into a market like this will only result in one outcome – poor returns.

Do Not Dollar Cost Average Into A Declining Market

Before, I mentioned that there were two reasons that I though dollar cost averaging into a declining market was a bad idea. The first was that it doesn’t make sense to make bets (trades) that you know are going to be bad (because the stock market will continue to fall). If you think the market (or a specific stock) has farther to fall you are best served by keeping your money out of buying new stocks all together. Why lock in at a price that you think will continue to drop? It just doesn’t make any sense and was the point that I made above with all those pretty graphs and stunningly awesome commentary.

The second reason is very much like the first, but slightly different: why invest money in a stock market that you think you will lose value over the course of the next couple months when you can get sure money by putting it into a high yield savings account? You should go with the sure-thing money all the way because you saddle yourself with losses when you buy into something that you think has yet to reach its bottom. Why not save the money until you are certain that the decline has stopped?

This makes much more sense to me. My solution to the current conditions would be to stop any scheduled stock purchasing plan that buys stocks on set time intervals (like dollar cost averaging) and instead sock that money away into a high yielding savings account until you think that the market has hit bottom, leveled out, or started rising again. I’d bet you $10 if we met in person that the return would be better on your money than if you continued to dollar cost average while the market is in decline.

  1. This is the fundamental assumption of all investing strategies other than short selling, so if you find fault with Dollar Cost Averaging here you have to find fault with practically every other investment strategy as well []
  2. Savings account information is the current annual percentage yield on the WaMu, now Chase, brick and mortar savings account.  It is 0.15%. []

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