I was reading about Dollar Cost Averaging over on The Digerati Life this morning and found something immediately interesting. The articles makes a good point that if you were to look at how our stock market has performed in the last year, you’d likely have some good gains with dollar cost averaging. The reason why is that you would be buying a lot of cheap stock on the dip that we had at the beginning of the year.
She illustrates this with an example from Tomorrow’s Scholar, specifically with this chart below:
Does anything seem unusual about the numbers in the example? Give it a look and see if you can see what I see. The stock prices are taking the same “V” pattern. It even ends in a positive note, so the look extra nice. This means that the average you’ve buying at is lower than today’s price as long as it gets back to where it was (or goes a little higher). This isn’t what I’d call a “fluctuating” market at all. It has no high points where you are potentially overpaying for the stock relatively to where it ends up.
Ahhh, Data, you are a kooky and wonderful thing. You are like Play-Doh flexibly bending to into a different creations in the hands of many.
What would happen if you took a snapshot where the stock was rising up and then dropped to a level slightly below where it started. This is the inverse of the “fluctuating” market above. In this scenario you’d find that every step of the way you were “overpaying for the stock” relative to where it ends up. In this scenario you’d lose money with dollar cost averaging.
Now what The Digerati Life showed was very valuable. The chart she found is more or less exactly what the market did in the last year – which proves her point exactly. However, if you chose to dollar cost average into the opposite scenario that I outlined, (say technology stocks from 1998 through 2001), you’d probably come away with a different opinion. Who is to say the next year isn’t going to see growth before another drop-off?
I’m not trying to say that dollar cost averaging is bad. I do it myself because I believe in systematically putting system away. However, it can be important to question the data and see if it truly makes sense.