Dollar cost averaging index investing is the most frequently one-size-fits all strategy suggested by personal finance bloggers. There are many reasons. It is easy to follow. It promotes discipline. It is supported by Nobel Prize winners(*). And perhaps most conveniently, everybody else supports it, so you don’t have to think about justifying it further(**).

(*) Pop-quiz: Name a couple of Nobel prize winners whose fund failed resulting in systemic problems that had to be bailed out.

I have questioned this collective wisdomherd behavior behind index investing before (here, here, and here). The problem is that index investing basically attempts to free-ride on institutional, mutual, and pension funds (larger drivers of the equity market) which naturally have their own agendas.

(**) Yikes!!!

There is a problem in perception as well. Anyone who buy stocks often fancy themselves investors,. Yet buying regularly with no concept of valuation is not investing anymore than sitting in your car while making engine sounds with your voice is driving. Such “investing” is simply saving. In that sense dollar cost averaging maybe be considered a form of saving denominated in the productive capacity of the country rather than in its currency, where the currency is nothing but a claim on its production. In other words, the choice is simply made in terms of saving in future products or future productive factors.
This savings-over-investments mentality creates a demographic problem. The boomer generation certainly supported the run up in stocks their most productive years in the 1980s and 1990s. Now, their retirement turns the previous tailwind into a headwind as they all pull their money out of the market about as fast as they put it in.

I commend either way. Savings is good! But don’t call it what it is not. Investing is the process of spending savings to purchase something of value to increase future returns. For individuals, this is not done by buying a broad basket whether it be productive factors or products. It is not done by buying at any price. What kind of deal is that anyway, say, going into a supermarket and buying a bit of everything in proportion to what everybody else is buying. Is that a deal? Think about it. Who benefits if the mass of people follows this advice? Yup, that’s right, the supermarket, not you.

It is easy to see why this would fail to provide superior returns. Businessweek recently wrote an article that summarized how buying and holding the market for the long run often required some staggeringly long runs. Here are some numbers for the longest periods during which the market was lagging inflation:

  • U.S 16 years (1905-1920)
  • Britain 22 years (1900-1921)
  • France 53 years (1900-1952)
  • Germany 55 years (1900-1955)
  • Japan 51 years (1900-1950)
  • Italy 73 years (1906-1978)

That is a long run indeed. So, you may argue that these periods have been selected. Of course they have. You can however find other periods at later times, even recent in your lifetime, that span decades. A span comparable to a normal person’s “investment career”.

But what about dollar cost averaging? Dollar cost averaging is a sword that cuts both ways. If you DCA in a market that first goes down and then goes up again to close at the starting price, you benefitted. If you DCA in a market that first goes up and then goes down again to close at the starting price, you lost. Dollar cost averaging is not supplying any free lunch to anyone. It only spreads risk equitably. Consider that there are probably a comparable number of people dollar cost averaging out of the market, namely those retiring who need a certain amount each month. Why would one group benefit from another(*)?

(*) If they did in any predictable fashion there would have been someone to arbitrage this gain out already.

In conclusion: DCA, buy and hold, and index investing are all good, but they are not a silver bullet. They are going to make you richer than your peers if you stick to them, but it is not due to their superior strategic virtues. Rather it is due to the discipline which you have and others do not. If you want to produce superior returns, you have to provide some kind of value. If you have buy shares when they are cheap and sell when they are expensive (trivial in theory, hard in practice). You have to provide liquidity when the market is starved and accept liquidity when nobody wants it. You have to take risk, when everybody is risk averse and be afraid when everybody is complacent. TANSTAAFL!

Much thanks goes to DK for contributing to the “coffee fund”!

Originally posted 2008-11-26 06:28:36.