Dollar cost averaging is a very common strategy among individual investors. It doesn’t really involve doing anything, but doing nothing is always better than doing something wrong.
Nick Magiulli, an analyst with Ritholtz Wealth Management, is obviously a big fan of the strategy of dollar cost averaging. He goes as far as to claim that his recent blog post on this topic is “the last article you’ll ever need to read on market timing. It’s a bold claim, but I’m not messing around”, he adds.
It is a bold claim indeed, and a very ambitious one as well, given how rich a topic this really is, considerably richer than just deciding between dollar cost averaging and buying on dips.
Dollar cost averaging is a popular strategy indeed, for the simple reason that people invest in this manner naturally. Dollar cost averaging is just a fancy name for investing a certain amount periodically, every pay or every month, habitually, and does not vary in its approach at all.
We might be in the midst of a market crash, but the dollar cost averaging investor just plods along, investing their $100 a month or whatever they can afford to each month regardless of market performance. When prices move lower, this fixed contribution amount will purchase more shares, and when the price rises, less shares, and it is felt by some to take what would obviously be an undesirable situation, depressed value, and turn it in one’s favor to some degree by purchasing the dips that are created with this.
The strategy of buying on dips is quite distinct from this, although it really doesn’t function well at all as a broad, overall strategy with investing, because the market moves both ways, and this therefore this restricts our participation to some degree at least when prices are moving in an upward direction.
Buying on Dips is a Bad Idea for Individual Investors
Buying on dips would not be a suitable strategy by any valid measure to the incremental investing that people tend to do, setting aside a portion of their income to invest in other words. There are a number of reasons for this, but the main one is probably that this would have their money sitting on the sidelines too much when it should instead be invested.
During bull markets, this has them sitting on their funds while they wait for these dips. We can define a dip any number of ways, but long-term investors would be waiting for significant pullbacks, which may quite infrequent or even absent from many bear markets.
Stock prices always vacillate, on a monthly chart, on a one second chart, and with everything in between, and one of the tasks with buying on dips is to determine whether a certain dip qualifies. If it does, the next step, and the more important one, would be to try to determine whether this is the bottom of the move or not, a challenging task for even the pros and one that tends to be even more challenging for casual investors.
Therefore, at least for individual investors, this match should be seen as a no-contest, as dollar cost averaging requires absolutely no skill, and can be followed perfectly by anyone, and also does not tempt investors to monkey around with their investment plan and risk make mistakes with it.
Buying on pullbacks is not suited at all for this style of investing, even if one were very skilled at predicting these dips, because even then, our money would be stuck on the sidelines a lot of the time, and especially during bull markets, while other investors continue on with their investing and add to their positions during these fortunate times.
This strategy does have its place nonetheless, and institutional investors buy on pullbacks to build positions all the time, and these actions actually propel reversals or at least significantly contribute to them quite often. They of course do not limit themselves to this strategy and will buy on the way up as well, and limiting an investing strategy to just buying on pullbacks does serve to set up this side of the evaluation as a sort of straw man, in other words weakening it and then attacking it.
While deciding how to gauge these pullbacks is the biggest challenge of buying on dips, Magiulli claims that a strategy of buying on dips will be inferior to dollar cost averaging, in other words doing nothing at all, even if we are omnipotent and know for certain where the lows will be.
He does provide some statistical data to support this, and it’s not hard to imagine this being valid, because cash is being withheld at inopportune times. In order for keeping money out of the market to work, or even make sense, we need to see a net loss in the market while money is being withheld, and this is an absolute requirement in fact not to end up worse off.
The buy and dip strategy that is being used here in his example does not do this at all, and in fact, tends to do the opposite. Whether we know where the dips are or not therefore won’t matter.
Market timing also derives most of its power by increasing the amount out of the market during pullbacks, when it is to our advantage to be out of the market, but in Magiulli’s comparison, selling is not allowed. This is where the straw gets laid on the argument.
This is Far from Showing Market Timing Itself Is Inferior
If we had ominipotence, we would be both buying on dips and selling at peaks, in a manner that wouldn’t just beat anything else, it would be timing things perfectly. While dollar cost averaging may clearly beat Magiulli’s dip strategy, we need to ensure that we understand what it is beating here, which is this particular strategy only.
Magiulli clearly goes well beyond this when he tells us that “if God cannot beat dollar cost averaging, what chance do you have”? God can of course beat dollar cost averaging, and mere mortals can as well, provided that their means of doing so aren’t limited to a single approach that is indeed inferior.
Beating dollar cost averaging will take some skill though, and if one does not have such skills and has no desire to learn how to do such things properly, then an unskilled attempt at timing their investments will likely underperform a hands-off approach, as we can do both good and harm with these decisions, and poor ones will be punished in time.
The idea of investors timing their investments has far from been defeated by all this, even though it does quite convincingly steer us away from the buy on dips style of investing. Very few people would ever use such a strategy and seeing their money pile up in cash while markets march up would be good enough for many people to wonder how this can be a good idea.
Timing the right way involves us instead holding on to and building positions when conditions are favorable, and reduce our exposure when things are not looking so good and the trend is in the other direction. Some may even take the other side of things during bear markets, which can add to the differential from doing nothing should one choose to add this and trade the plan well.
The idea that we can help ourselves by timing our investments therefore hasn’t been rattled at all by Magiulli’s arguments, let alone been defeated by them. We do know one thing that doesn’t work though, and there are a lot of investors who get tempted to buy more on dips, and do not understand the additional risk that they are taking on, so if Magiulli’s piece serves to have people think twice about these things, it will be of benefit for this reason at least.