So you’ve decided to invest in the stock market by setting aside a certain amount of money each month (or other time frame) and placing it into a particular stock. I briefly discussed this concept earlier in chapter 14, “Hopes and Dreams.” People do this often. It’s called dollar cost averaging. The premise seems (be careful of that word) to make sense. By investing a set dollar sum in a stock on a regular basis, you’ll buy more shares when the price is down and fewer shares when the price is up. Those lower-priced holdings will prove to be smart purchases when the shares rebound, or so the reasoning goes. To those who believe that the underlying company looks sound and has bright prospects, the approach makes sense. But hold on.
Folks who follow the dollar cost averaging method don’t stop to consider a scenario in which the stock fails to rebound. The fact is that many stocks don’t come back—some not for years, some not at all! If you regularly commit capital to a stock that’s lodged in what analysts like me call a “major downtrend,” you’ll usually run out of capital to invest well before the shares in question hit bottom. The market’s staying power is greater than yours. Remember that. Go online and look at the household- name companies whose shares are significantly off their peaks. Some are selling at fractions of what they once were; some have gone through bankruptcy, slashed or omitted dividend payments, or suffered through a nasty bear market.
If we look at dollar cost averaging in terms of dating, the shortcomings are noteworthy. It’s like chasing a person who is poor match for you, practically begging them to get involved in a serious relationship, and then, as it becomes increasingly clear how incompatible the two of you are, marrying them, buying a home, and starting a family. It’s as if you’re saying, “Look, Jeff, since we’re basically incompatible, don’t really share similar interests, and don’t care greatly for or trust one another much, let’s become more deeply involved in our dysfunctional relationship by going shopping for an engagement ring, planning a wedding neither of us really want, and look forward to a probable deteriorating bond over time complete with a mortgage and kids.” Any clear-thinking person would halt such a relationship immediately! (That’s why I think relating investment behavior with one’s capital to personal behavior in one’s life makes sense. It allows for a clearer take.) You can’t afford to be seriously hurt financially by adding hard-earned capital to a steadily sinking stock. Personally, I’ve never used that approach, nor will I ever.
A broker called me many years ago and related how he was using the dollar cost averaging concept (I’ll never call it an investment strategy) to purchase shares of a particular stock at regular intervals. As I looked at the chart patterns and gathered other technical analysis information on the stock, my frown grew increasingly pronounced. I remember telling him not to proceed with his plan, that the signs suggesting that the shares’ supply-demand relationship was improving were absent. He told me he wasn’t concerned because if the stock continued to go lower, he would simply keep buying those shares at increasingly attractive prices. Is ugly beautiful? Is down up? Is bad good? Is lower higher? That’s basically the philosophy you’re resigning yourself to when continually buying a stock in decline. You’re doing things backwards—upside down, in fact. In this particular case, I suspect that the young broker was calling me for an affirmation of his plan. He had decided to pursue it regardless of my counsel. But as I said earlier, what I tell others to do with their money is based on what I would do in that very same situation with my own money.
After trying to convince him, to no avail, that this was not a course of action to take based on my brand of research, I decided to ask him the following question: “Based on what you’re telling me, why don’t you hope that the underlying company goes bankrupt?” I think the question got to him, because he paused before responding that if the underlying company went bankrupt, his shares would go to zero. Whereupon I remarked, “Yes, but look at all the extra shares your monthly allocation can buy then.” As best as I can recall, I never heard another word from him.
Sometimes I have to be blunt by way of example, especially in this case where the broker was relatively new to the business of investing and probably hadn’t experienced the negative side effects of following potentially dangerous market beliefs like this one. I suppose I needed to convey it to him in a way that wouldn’t soon be forgotten.
A cousin of dollar cost averaging, kind of like “Son of Godzilla,” is the “I’ll just buy more” investment method. This is a strategy I hear when I ask investors the point at which they’d consider selling their shares if the position wasn’t working out. Rather than investing a predetermined dollar amount in the same security over regular intervals to buy more shares as it weakens in price and potentially lose money in an orderly fashion, this “seat of the pants” approach seeks to add capital to a declining position in a haphazard way to potentially lose serious amounts of capital. Both cases suffer from the same investment ill: chasing poor performance. And, may I say, refusing to acknowledge the potential for loss.
Moral: Getting more deeply involved in a losing situation is often a detrimental choice in one’s personal or monetary life. And justifying why we made the wrong decision instead of extricating ourselves from it is a ticket to remaining aboard that sinking ship. Dollar cost averaging may sound sensible, but theory and practice couldn’t be further apart when it comes to investing in the stock market.
(To be continued...)
This excerpt is taken from “Relationship Investing: Stock Market Therapy for Your Money” by Jeffrey S. Weiss. To read other articles of this book, click here. To buy this book, click here.
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