Dollar Averaging - Good or Bad?

[aleckara]

I think that dollar cost averaging isn't really about the money as such. I think it can be a trading technique that can make money, but there are assumptions in that technique:

1) The company isn't hiding anything, and you have accounted for likely economic changes
2) The overall trend is up for the stock, and you simply bought at a peak (didn't pick the dips correctly and there is a slight trading dip).
3) You are looking at accumulating a business share more so than generating trading income/cash and you are doing it with income from another source (like your job instead of upfront capital - hence Mum and Dad investors particuarly are comfortable with this strategy).
4) I think that this is a very bad strategy if you are geared in your investments in any way.

I have been guility of this trading technique in the past but haven't done it that aggresively. What I do is look at it impartially at the time it has dipped. Is it likely to go down further? (If I'm not sure I don't buy). If I'm sure it will go down further I sell my existing holding. The funny thing is that when I have done this I have made a profit. Just try not to convince yourself that there is value "everyone will always need electricity" for example for BBP isn't a good argument because you are discounting the price people are willing to pay for that product.

So in other words it is a trading technique but it needs to be combined with tech analysis info, fundamental analysis info and an understanding of the market currently and why. Soemthing most people don't really understand too much.

 

[AlterEgo]

Let’s consider this theory that some people believe that all ‘blue chips’ will eventually recover from their falls. Take AMP for example, it has recovered from it’s low’s, but is still HALF the price it was 10 years ago! How do you think your portfolio would be looking right now if you kept averaging down on each drop? Not very good I’d imagine.

 

[tech/a]

Just on AMP.

My Father now 85 asked at the time it was listed--what to do with his free 6000 shares.
I told him to sell them at listing.
The only time Dads ever done something I suggested.
He got $24.18.

He to this day still enjoys a scotch on the topic.

 

[cuttlefish]

Well Michael I cant see Dollar Averaging---averaging down as sound M/M.

Someone mentioned TOL.

I'm no fundamentalist but they believe that the company is getting close to good buying.
Past history may well give them this impression.
Currently its tanking---Fuel costs,Drop in demand.This is going to effect the bottomline that which the analysis is based upon.

In 12 mths time as youve been averaging down the stock could well--due to economic factors beyond its control---be valued way under your initial valuation---then what youve bought all the way down to a level which is NOW true value.

The market know this and as such the price tanked well before the fundamentals showed the altered value in the balance sheet.

Which takes care of Cuttlefishes --this is a rediculous arguement.
I agree its is just as stupid as averaging down.

But prove me wrong people.

I agree with your example here Tech.

Without knowing the specific details of TOL but as a general concept if holding a transport stock that is highly dependant on oil prices as an input cost then clearly a rising oil price scenario is a macro factor that will affect this stocks ability to generate the income levels it has in the past.

Thus in the early stages of oil price rises these sorts of stocks should be reduced or offloaded and then the decision made to buy back in when it returns to a value outlook - i.e. when oil prices have fallen again, or when they have clearly demonstrated their ability pass the input costs on to the market and still maintain margin, market share and growth.

So averaging down into this hypothetical transport stock would not be sensible and its a good example of why averaging down as a general approach is often a very poor investment/trading strategy - as has been pointed out it would have the effect of increasing the exposure to a stock that has a negative outlook.

On the other hand the opposite situation can and does occur - a good stock that has an improving outlook due to macro factors will get sold down due to overall negative market sentiment or will rise at a slow rate that is not consistent with its rapidly improving value look (where I'm defining value as income generation ability compared to other asset classes).

 

[aleckara]

Let’s consider this theory that some people believe that all ‘blue chips’ will eventually recover from their falls. Take AMP for example, it has recovered from it’s low’s, but is still HALF the price it was 10 years ago! How do you think your portfolio would be looking right now if you kept averaging down on each drop? Not very good I’d imagine.

Then I would argue that they are wrong. When a blue chip falls like that my limited chart knowledge tells me it isn't a sure bet and I stop. I would of probably bought AMP when it stopped falling and brought my average down at its low when I could see it was going up again. It's all about whether your willing to take on that increased risk being exposed to that stock. I see cost averaging as being a coincidence, not an strategy for the sole purposes of it being a strategy. (i.e if it is a good idea take it- if not then don't). Different situations call for different trading strategies.

 

[Synergy]

The thing with averaging down for me is that every trade, regardless of whether you already hold the stock or not, needs to be an indipendent decision.

I think our minds view stocks we hold very differently to those we don't. If you see a stock in a nasty downtrend, you don't want to buy it. But if you hold that stock, for some reason you feel the need to buy more.

I'm pretty sure this relates back to the 'always needing to be right' theory. If you average down, there is in theory more chance of being right on that stock. You lower your buy price, so it needs to rise a smaller amount before you are back in the money. But is that a better decision than entering a new stock, that is probably more liekly to rise??

I have the same opinion on pyramiding, although with pyramiding, you already have a larger than average position in that stock because it's already risen. Buying even more means you are even further increasing the risk of holding that stock.

 

[Trembling Hand]

No one has explained how you money manage Averaging down yet??

Please someone???

Anyone

:run:

 

[tech/a]

Buying even more means you are even further increasing the risk of holding that stock.

I can average into a rising stock (pyramid) without increasing risk.
I cant average down---continually---without increasing risk.

Seems there needs to be some visiting of Risk for some here.
In particular mitigation of.

 

[AlterEgo]

“It is foolhardy to make a second trade, if your first trade shows you a loss. Never average losses. Let that thought be written indelibly upon your mind.” – Jesse Livermore

 

[barney]

I actually don't see DCA as the bad guy here. Its more about the position size employed which can/will get you into problems (I speak from experience on that one )

3 rules if you like to DCA which may actually make trading less of a risk imo ..

1) Make sure as much as is possible that the stock is fundamentally sound (No off the wall specs)

2) Istead of taking the full position size up front, only purchase say one third of the shares ............ This gives the stock more breathing space, and your stop loss can be relaxed accordingly to still fit sound MM priciples

3) If the stock drops, but doesn't hit your stop loss, you only DCA if the trend reverses back to the positive direction. If it continues down and you get stopped out, you will lose a smaller % of your capital (Some discretion is obviously required)

Once you have two thirds of your desired position open, the stop loss will obviously need to be tightened ( but still not as tight as it would have been if the full parcel was purchased originally) ............ Just my observations, so should all be taken with a grain of salt ..... "Would you like fries with that"

 

[tech/a]

Just some comments here Barney!

I actually don't see DCA as the bad guy here. Its more about the position size employed which can/will get you into problems (I speak from experience on that one )

3 rules if you like to DCA which may actually make trading less of a risk imo ..

1) Make sure as much as is possible that the stock is fundamentally sound (No off the wall specs)

2) Istead of taking the full position size up front, only purchase say one third of the shares ............ This gives the stock more breathing space, and your stop loss can be relaxed accordingly to still fit sound MM priciples

How do you do that when at the time of buying your analysis says its a good thing---you dont buy stock expecting the Average down--do you?
3) If the stock drops, but doesn't hit your stop loss, you only DCA if the trend reverses back to the positive direction. If it continues down and you get stopped out, you will lose a smaller % of your capital (Some discretion is obviously required)

So how do you determine positive direction?
Stopped out---Ehh thought there wasnt any use of stops thats why you find yourself in a position of averaging down in the first place.


Once you have two thirds of your desired position open, the stop loss will obviously need to be tightened ( but still not as tight as it would have been if the full parcel was purchased originally) ............ Just my observations, so should all be taken with a grain of salt ..... "Would you like fries with that"

Stops again you wont need to $$ average if your using stops
All good theory Barney but poor on application!

 

[barney]

Just some comments here Barney!

Pre curser .... I'm pretty crap at this "quoting" previous posts etc ... so for the point of the exercise, I have posted Tech's comments in RED, mine in Black, and my quotes from the previous post in GREEN ........... DOH !!:homer:

G’day Tech, As always, appreciate your comments. I guess what I’m getting at here is “my” form of Dollar Cost Averaging …….. Everyone needs to formulate their own plans of attack


How do you do that when at the time of buying your analysis says its a good thing---you dont buy stock expecting the Average down--do you?

Perhaps we should actually do just that!! Smaller position sizing at the outset may actually be a better form of trading ……… If we are “generally” correct about the stock but it retraces, we then increase our position with a better average cost (bear in mind I’m talking more about blue chips here … not specs) …….. If it fly’s as we’d hoped, then at worst we have a smaller opening position …………. After that, pyramiding becomes a bonus option

3) If the stock drops, but doesn't hit your stop loss, you only DCA if the trend reverses back to the positive direction. If it continues down and you get stopped out, you will lose a smaller % of your capital (Some discretion is obviously required)

So how do you determine positive direction?

Technical Analysis is all we have ……….. If the trend is up, buy … if down, sell … Of course everyones T/A may not be of the same standard .. (mine is improving, but a long way from being great)

Stopped out---Ehh thought there wasnt any use of stops thats why you find yourself in a position of averaging down in the first place.

That’s where I think DCA is misused/misunderstood ………… If the DCA is “pre-planned”, a stop SHOULD still be in place, but instead of putting all our eggs in the one basket (full position size) …….. we should consider a partial position to “test” the water (assuming T/A is not an exact science, and fluctuations are part of the game)

Hope that all makes sense


PS As an edit to finish ............. Can I say that if you are going to DCA, then your total $ "committment" to any given stock should be NO MORE than what you may have considered as an initial "committment" to that stock (based on standard MM principles of 1-2% of capital etc) ............ Its hard to explain stuff via typing on a website, but basically DCA to me means allocating "X" amount of $ to a stock, and then "spreading" the risk (if necessary) to achieve the desired result ................
A stop loss is still necessary ............. F/A and T/A are both still necessary ............ If all are incorporated into the DCA, then it should be no more risky than any other form of trading .............. However, averaging down based purely on price is a recipe for disaster ..... I know, cause I've been there big time !! ............... Cheers.

PPS In no way am I trying to support my opinion as being correct .... it is simply my observation from a mathematical point of view ............. Maths I was good at ... Trading I'm ..... mmmm ...... "do you want fries with that??"

 

[BSD]

The maximum downside from averaging down is 100%

The upside is unlimited.

All depends on your ability to value a stock does it not?

Or dumb luck?

The two concepts are often confused. But too much leverage can make it all go wrong too (Livermore as an example may not be a great role model unless you are prepared to go broke 4 times before killing yourself).


Averaging down is just a decision to buy more of something you already own. Another independent investment. The fact you already own it is irrelevent.

It could be a coincidence, but all of the largest and most successful positions I have carried were 'averaged down' at some point. In fact averaging down in time of market panic has been the best strategy I have ever employed.

For example, some of the Opes Prime selling created some of the finest opportunities I have ever taken advantage of and all of them required averaging-down a position. Loading up on stocks trading at 40% discounts because a bucket shop was going down the toilet have locked in some great numbers in an otherwise poop market.

Looking behind the price action, as opposed to simply reacting to it, makes more sense to me.

Not everyone has a investment timeframe measured in days.

So if your ability to value something properly is not in question - fill your boots when the stock is down for reasons not affecting your valuation.

But, if you don't actually have a valuation and are just long a stock because of a tip or an interesting chart - then run like hell when it drops.

 

[nizar]

The maximum downside from averaging down is 100%

The upside is unlimited.

This is true of going long any stock. Averaging down has nothing to do with it.

 

[Trembling Hand]

The maximum downside from averaging down is 100%

LOL.

What is the loss of not putting that good money into a stock that is running.

What a joke!!

 

[BSD]

No joke

The point is that it is not the act of averaging down that is the problem/opportunity - it is the selection and subsequent performance of the investment.

I would no sooner put money into a stock because it had fallen than I would because it had risen. Some people tend to have their good money in stocks before they run.

 

[tech/a]

No joke

The point is that it is not the act of averaging down that is the problem/opportunity - it is the selection and subsequent performance of the investment.

I would no sooner put money into a stock because it had fallen than I would because it had risen. Some people tend to have their good money in stocks before they run.

You confuse me. Above is a contradiction?
My interpretation of AVERAGING DOWN.
Is that your buying more stock at prices below your initial buy,your NOT adding to a position which is already in profit.
By doing this your adding to risk not diminishing it.
Your adding to opportunity cost as TH points out---you have funds tied up attempting to dig you out of a hole.

If your valuation is correct the point at which your initial buy was taken will be taken out. Chasing it down this could take months--if not years.--could take a week---you just don't know. What you do know is that its NOT moving in the direction of your analysis.

Taking Barneys Idea of smaller initial position sizing Id be doing the EXACT opposite--setting a stop and taking a SMALLER loss.
Putting it on my watch list for either
(1) Looking for an END to the correction then buying again at low risk.
(2) Setting a buy again at the point of my failed initial entry.

Averaging down doesn't have stops as far as I'm aware---why on earth would you buy more as a stock is approaching a stop?

Buying pullbacks in an already profitable stock is another thing entirely.

I would no sooner put money into a stock because it had fallen than I would because it had risen. Some people tend to have their good money in stocks before they run.

Yet you condone placing money in a stock which is falling---in fact more than once---averaging down.
Doesn't make sense.

So you wouldn't put money in a rising OR falling stock and according to you ---don't be one of those that puts money in a stock BEFORE they run

Doesn't leave any further option--that I can see.

 

[Trembling Hand]

No joke

The point is that it is not the act of averaging down that is the problem/opportunity - it is the selection and subsequent performance of the investment.

I would no sooner put money into a stock because it had fallen than I would because it had risen. Some people tend to have their good money in stocks before they run.

Can you PLEASE tell me how you do this in regards to money management.

You buy a stock thinking it is going to go up. it does. do you buy more or have you got enough? If you have enough in regards to position size then surely buying more lower if it happened to drop can only mean 2 things.

1. If stocks take off after your 1st purchase you will not have a very big holding.

2. You are taking on too large a size for your account in what till this point is a loser.

How do you avoid loading up on rubbish while not having full size position in a stock that run?

 

[motorway]

http://www.studyfinance.com/jfsd/pdffiles/v13n1/marshall.pdf

As the title suggests, this paper compares two “formula” or mechanical investment techniques, dollar
cost averaging and a relatively new proposal, value averaging, to a form of random investing to
determine if any technique yields superior investment performance. Results indicate that value

averaging does provide superior expected investment returns when investment prices are quite volatile
and over extended investment time horizons with little or no increase in risk.

These results are quite
surprising based on other research supporting the Efficient Market Hypothesis and the fact that any
actual performance attributed to value averaging does not result from any temporary inefficiency in
market prices.

as to dollar cost

“Does DCA yield
superior investment performance compared to a purely random investment technique?” They found, with 99%
confidence, that there is no statistical difference in the IRRs achieved by each technique.

They also found, with 95%
confidence that each technique had the same risk as measured by the standard deviation of the IRR distributions.
They conclude that the null hypothesis is valid and that DCA is not superior to random investments.

While I use neither mechanical system

I think there is some insight in this
comparison between DCA & VA





motorway

 

[BSD]

We are obviously talking about different types of investment styles. I am not disagreeing with your styles, just noting mine.

I am a firm believer that a lot of investment success is dumb luck and hence I always make sure that a large majority of my net wealth is managed by a number of other people else both passively and actively.

So in this context, my 'style' of investing being discussed here is not applying to 100% of my funds. This is relevent to discussion of money management and position size.

I look for plays to be in for a number of years with big upside based on my fundamental analysis.

Is that your buying more stock at prices below your initial buy,your NOT adding to a position which is already in profit.
By doing this your adding to risk not diminishing it.
Your adding to opportunity cost as TH points out---you have funds tied up attempting to dig you out of a hole.

If your valuation is correct the point at which your initial buy was taken will be taken out. Chasing it down this could take months--if not years.--could take a week---you just don't know. What you do know is that its NOT moving in the direction of your analysis.

I dont mind having funds tied up. My style relies on large swings over years not next week. My view is that the price will meet the valuation. Often the event that precipitates price meeting value is a takeover or some other instant event.

My results through this style have by far and away compensated me for not trying to back the fastest horse everyday.

I noted earlier that price action does not come into my calculations, only the drivers of the price. I am more interested in understanding why the price is moving and if it is not something that affects my valuation of the stock - I dont care either way.

The Opes Prime forced sell down as an example. Plenty of ugly price action based on nothing more than a forced seller - a wonderful opportunity. It just happened to be a case of 'averageing' down.

Whether it took a week or six months to clear the stock it was always going to happen. Just wait for the crossing to go through and get set.

Taking Barneys Idea of smaller initial position sizing Id be doing the EXACT opposite--setting a stop and taking a SMALLER loss.
Putting it on my watch list for either
(1) Looking for an END to the correction then buying again at low risk.
(2) Setting a buy again at the point of my failed initial entry.

I have different money management to most. In the last five years I would have invested in less than 15 stocks. I would never have owned more than 4 stocks at one time and for a long time 1 share represented 90% of my portfolio.

When you hit a 25 bagger and are happy to hold for the longer term - this is something that occurs. I guess I dont value piece of mind as being worth turning a 25 bagger into a 18 bagger by paying so much tax.

In the context of the time and upside, if something falls 5% after purchase, I dont see it as a 'failed entry'

So you wouldn't put money in a rising OR falling stock and according to you ---don't be one of those that puts money in a stock BEFORE they run

Doesn't leave any further option--that I can see.

My point is that I do not buy or sell based on price action - very different from a lot of people here. I will typically 'build' a position over some time and this would more than likely involve buying on down days

Friday case in point, WTF does the Dow being down 300 points have to do with the value in 2012 of a mine in Africa? Buggerall, but it moves the price and provides an opportunity to buy cheaper.

Can you PLEASE tell me how you do this in regards to money management.

You buy a stock thinking it is going to go up. it does. do you buy more or have you got enough? If you have enough in regards to position size then surely buying more lower if it happened to drop can only mean 2 things.

1. If stocks take off after your 1st purchase you will not have a very big holding.

2. You are taking on too large a size for your account in what till this point is a loser.

How do you avoid loading up on rubbish while not having full size position in a stock that run?

I don't mind averaging up. Typically a liquidity thing, but also a result of increased confidence in a call. As I noted, I don't mind getting very large into something as a % of my account.

I don't buy rubbish. I spend a long time evaluating something before purchase. I am constantly fascinated by the prices people pay for questionable assets because the market is 'hot'. Not a game I play.

Probably bordering on 'off topic' but essential in explaining my original point that averaging down is neither 100% bad or good. Not all averaging down is people chasing losses and not everyone chases short term trends.