Dollar cost averaging: Timing the market vs time in the market

The stock market is relatively very volatile; astronomical changes can occur in very short periods of time. In fact, it is said that half of the gains of a stock, if held for 40 years, is contributed by just the best 10 days.

In the same vein, if you successfully missed the 10 worst days while holding a stock for forty years, your capital gain at the end of the 40 years would be about 100% up.

The analogy might be considered hypothetical but it attempts to show why good entries and good exits are very important in the market. Many investors spend a great deal of time trying to predict the best entries and exits for stocks because, as has been shown in the analogy above, getting in on a good day or getting out on bad day can be really rewarding.

Predicting the market is very tempting, but according to the theory of Efficient Markets, it is technically impossible to do so. Many experts and players like Motley Fool who claim to do this might actually be leveraging on the Rational Expectation Theory and herd effect which simply explains how a community of people acting in the same way that conforms to what can be expected in the future by doing so, creates a self-fulfilling prophecy that helps bring about that future. That is to say, if many persons believe that a stock will fall and then go on to sell that stock, the stock will fall eventually, not because of their predictions but because by acting in herd, they created the effect which they predicted.

What is it going to be—timing the market or time in the market?

As we have seen, predicting the market is nearly impossible and might only be attempted by very influential economic players with an enormous community.

You’re better off working with confirmed strategies than trying to predict the market if the description given above does not match who you are. One of the strategies that take care of the troubles, mistakes and anxieties of trying to predict the market is Dollar Cost Averaging.

Dollar cost averaging is a strategy in which you invest a consistent amount on a recurring basis, regardless of market conditions, to help ensure you don’t miss out on the upside potential of the market while maintaining protection against the downside.

For example, let’s say a hypothetical stock has monthly stock prices of $50, $43, $65, $40, $51 and $45 respectively for a period of 6 months. Lump sum investment as opposed to Dollar Cost Averaging would try to guess the best time of entry—the time the stock is at its lowest—invest a lump amount all at once. If the prediction is right, a very good profit would be accrued but if the prediction is wrong, a very good part of the investment would be lost.

Investment shouldn’t be based on luck. As a beginner or moderately skilled investor, you want to focus more on mitigating risks than amplifying profits. With Dollar Cost Averaging, you invest fractions of the capital, for the 6 months duration which will translate to the price of $49 per share (taking the average of the price per share for the 6 months). That way, you may not have gotten in with the best price of $40 per share, but you have also dissolved the chances of getting in in the worst price of $65 per share. You also rid yourself of the guesswork and emotions of choosing a good entry point.

Dollar Cost Averaging also helps investors circumvent the risk of inflation, especially for investors in the US stock exchange who whose native currency isn’t dollars. This is very important because the best entry point for a stock might coincide with a time when the price of dollar to your local currency might be very high. As a result, your gain is offset by inflation. With dollar cost averaging, you buy at different points in the inflation curve which then averages out.

Dollar Cost Averaging does not take advantage of the very good days, but then lump investment, which does, exposes you to the very bad days. There should have been an in between, or maybe there is.

A slightly better alternative

After studying the market and deciding the “best” entry points. You could decide to invest lump sums in maybe 3 stocks. A little twist to this strategy is that instead of investing periodically as in Dollar Cost Averaging, you balance out your portfolio periodically. So if you invested $100 each in 3 stocks (stocks A, B and C), you choose a balancing timeframe, say quarterly. After a quarter for example and your investments in the 3 stocks had gotten to the values of $120, $90 and $105 dollars which aggregate to a portfolio net profit of $15. To balance out the portfolio, you take the profits of the high performing stocks to buy more of the low performing ones. In this case, you take $15 from the gains of stock A to buy more $15 worth of stock B to make your portfolio balance out to a value of $105 for each stock. This strategy has both the advantages of Dollar Cost Averaging and lump investing as it lets investors participate in the good days and in case of a bad day, you can buy at the new “low” with the gains of other high performing stocks.

Final takes

The most apparent question most beginners and even some seasoned investors ask before trying out a strategy is “how much more gains will this strategy make than the other?” While this is a very pertinent question, one must consider before embarking on an investment, as the main goal is to grow wealth, there are even more rudimentary questions one must ask before considering gains. Questions that circle around your personality and risk aversion.

There are many strategies when it comes to investing and two persons might be using the same strategies yet getting different results. Strategies might be identical but idiosyncrasies vary. The aim of many strategies is not to find one that makes the most money, but one that works best with your idiosyncrasy, risk tolerance and emotions. One that basically lets you sleep at night.

As a rule of thumb however, it is necessary that beginners mitigate risks to the barest minimum as “getting your fingers burnt” in your early days might be very traumatizing. Your early days in the stock market should be more about learning than earning.

If you are very risk averse or still new in investing, Dollar Cost Averaging or Lump Sum Balancing might be better options for you.

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Written by Jonathan Chinemerem