Investors Beware: Dollar Cost Averaging Deadly
By Moe Zulfiqar for Daily Gains Letter |
If the price of a stock or any other financial instrument is headed downward, should you buy more or sell? Investors are faced with this question every single day when they see their holdings decline in value. In situations like these, investors sometimes make a mistake of buying more of something when they should have been selling it—this is often referred to as dollar cost averaging.
At the very core, dollar cost averaging is simply buying a security constantly regardless of the price. The idea behind this method is very simple: investors don’t really have to worry about market timing or getting into a stock at the right price. This strategy can be used as a way to accumulate a security over time.
If an investor buys a stock while it’s going down, their thinking is that the average cost will decrease, and they will be able to profit more once the price rebounds a little—the price doesn’t have to return to the same point it was at before.
Look at it this way; you buy shares of ABC Inc. at $10.00 each. A few weeks later, you find that the price has gone down to $8.00—a 20% decline in value. You go ahead and buy even more shares. Now, if you take the average of the two prices you paid for ABC shares, you will find that your cost is actually $9.00—your cost has gone down by buying the stock at a lower price.
With this comes one question: does buying more when something is falling in price really add any value to your portfolio or reduce the risk? The cold hard truth is no.
While most investors may not realize this, so-called “dollar cost averaging” actually increases an investor’s exposure to risk.
Think about the example above with ABC Inc.; if an investor continues to buy more shares of ABC when its price is falling, they are simply increasing the risk in their portfolio. Remember, you must try to diversify your portfolio in order to make it immune to market fluctuations. In this example of dollar cost averaging, the investor doesn’t diversify; instead, they add more to one stock. Before buying, ask yourself this one question: while the prices are going lower, what happens if the price keeps going lower?
In addition to increasing risk in the portfolio, dollar cost averaging also increases transaction costs. Let’s return to our example above. An investor buys ABC Inc. shares at $10.00, and then bought at $8.00 again; this investor’s broker charges $10.00 per trade. This investor’s total transaction cost for ABC shares will be $20.00; on top of this, they still have a loss of $1.00 per share.
What dollar cost averaging essentially does is kill an investor’s profitability and increase their losses—even if they don’t buy more shares as the price goes lower.
Instead of making a mistake of buying more when the price of a stock is falling, investors must think long term and know that there will be fluctuations in the market. They should focus on asset allocation to keep their portfolio in line with their long-term targets. Constantly buying when a stock’s price is in a freefall is like trying to catch a falling knife—the end results will be a loss to the investor’s portfolio, delaying them from reaching their long-term goal.
Tags: asset allocation, dollar cost averaging, risk
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