February 9, 2022 – By: Jerry Nix | Freewavemaker, LLC
I opened my Facebook Freewavemaker Page this morning and was faced with this question from a reader I will call Kelly:
This is how I answered this person’s question … which may not be the best answer … but hey, I was typing on my phone while watching the morning news …
“Kelly that depends on what your confidence level is for Facebook. I personally don’t like the company and what they try to do in keeping conservatives quiet, but that does not mean I would not buy their stock or their options. I don’t like Walmart either but I do buy stock or options on them from time to time. That being said, there is nothing wrong with dollar cost averaging on large widely traded companies. Tech stock is a growth area and will be for a very long time. You know what they say, “Rising oceans raise all ships.” There are going to be waves up and down … but long-term things will be fine and so should Facebook, unfortunately. I cannot tell you if you should buy more or not … that will have to be a personal decision. I do think they are not going away … though I wish they were under different management … but expect volatility and protect yourself with either a stop loss order or insurance by using put options to lock in gains or reduce losses in the future. I hope this helps!”
With that I decided it is time for another article – this one on Dollar Cost Averaging for Profit.
When I was a financial advisor, advising people on how to invest in mutual funds years ago, I’d often use a story to describe what “Dollar Cost Averaging” is and how it could be used to profit with mutual funds. It can also be used in individual securities as well, though you can’t use a set amount (like you can in mutual funds) since you cannot buy fractional shares of a stock or ETF like you can in a mutual fund.
Many “stock guru’s” today warn that dollar cost averaging is a sure way to lose money long-term … but many others fully believe in its use. Those that advise against it are concerned that you may be doing so on a stock that is going to continue to decline in value. That would be throwing good money after bad.
If you have ever heard someone, say “Buy the Dips” unless they are a swing trader that will also “Sell the Highs” they are likely a person that believes in dollar cost averaging for the long-term. One name that comes to mind is Warren Buffett – the so-called “Oracle of Omaha” and founder and CEO of Berkshire Hathaway. Mr. Buffett believes in buying stock in companies that you will hold for a lifetime and buy more when the stock goes down in value. After all, if you paid $10 per share and the price suddenly drops to $7 per share for no other reason than some news or some large insider sold a few shares … why not buy more at a 30% discount from what you originally paid. The old saying is, “If it was a bargain at $10 per share – and you thought it was or you wouldn’t have bought it – it’s a tremendous bargain at a 30% discount.”
Another such person I believe does the same is Stuart Varney of Fox Business News. I listen to his show almost every morning from 9:00 AM till 12:00 Noon Eastern Time (not today because I am writing this article) and he always talks about his beloved Microsoft stock (MSFT) and wonders (with a grin on his face) if he should sell it or buy more of it. Especially when it goes down a few bucks in value. Though I don’t know the man personally and have no idea what he holds in his investment account … I’d venture to guess that one of his holdings (that he has bought more than once in his life) is MSFT, through all its ups and downs.
Here’s the story I used to tell about Dollar Cost Averaging:
Keep in mind this has been exaggerated simply to explain how it works to the common person who is not a savvy investor.
Mr. Investor decides after attending an investment seminar to buy shares of WXYZ fund when the price is at $10.00 per share. He invests $1,000 and is able to acquire 100 shares of the fund.
Just one month later Mr. Investor looks at his account statement and notices that the shares are now worth only $5.00 per share and his value has dropped from $1,000 to $500. He is down 50% in value and just a little bit upset.
Then the third month he looks at his account statement again and notices that his shares of the fund have plummeted to just $1.00 per share and his investment has lost 90% of its value and is now only worth $100.00. He’s furious and is ready to sell. As a matter of fact, he probably would if it weren’t for Mrs. Investor who reminds him that it’s hard for a mutual fund to fully go broke since it is made up of usually 100 companies or more and all of them would likely have to file bankruptcy. Of course, realistically, many of them would be merged into other funds if this were to happen … but this is a fictitious story so let’s continue.
Mr. Investor remembers the advisor that sold him on this idea told him to not invest more than he could afford to lose so he decides to “Hold on for dear life.”
The fourth month rolls around and Mr. Investor looks at his statement and sees the fund shares are back up to $5.00 per share. His account has gone from $100 in value to $500 in value. Needless to say, he is just a little bit happier … and decided to ride it out a little longer.
On the fifth month Mr. Investor notices his shares are back at $10.00 per share and his account is once more worth the $1,000 he originally invested. He has been traumatized and has bleeding ulcers over the fact that he almost lost it all.
What do you think he will do?
If you guessed get out while the getting is good … you are likely right. After taking a roller coaster ride like that most people would get out and either put the money back in the bank to earn next to nothing or find another – perhaps less volatile – fund to invest into.
Take a look at this drawing that I would draw out on paper while telling the story. Of course, I would draw it as I talked it.
Once I went through the first part of the story I’d turn to the lady of the house and ask, “Are women generally more patient and just a little smarter than men?”
Naturally the answer was, “Yes” or “Almost always!”
With that I’d begin the second part of the story.
Let’s assume that Mrs. Investor went to the same seminar and heard that you did not have to invest $1,000 you could actually sign up for payroll deduction or bank draft and invest as little as $100 per month into the same WXYZ fund. Since she did not have $1,000 to part with at the present time, she decided to invest $100 per month. She also remembered the Advisor saying that if doing it monthly you really wanted volatility in the account to work for you and not against you.
Let’s see what happens when a person believes in an investment approach and sticks with it over time.
Mrs. Investor invested $100 the first month and bought 10 shares.
The second month rolled around and with her $100 investment she was able to purchase 20 shares (twice as much as the first month’s investment).
The third month comes along and Mrs. Investor sent in her $100 and purchased a whopping 100 shares. She was getting happier because she remembered her grandfather (who happened to be a farmer) telling her, “If you can buy quality land at a lower cost per acre it would behoove you to do so as often as possible.”
By the fourth month the price was going back up and Mrs. Investor only bought 20 shares at $5.00 per share with her $100 investment.
Finally on the fifth month after investing another $100 and purchasing another 10 shares, Mrs. Investor – after listening to her husband Mr. Investor moan and groan about breaking even – decided to look at her own progress. This is what she found.
Here’s here investment over five months:
- Month 1 = $100.00
- Month 2 = $100.00
- Month 3 = $100.00
- Month 4 = $100.00
- Month 5 = $100.00
- Total invested = $500.00
Here’s her shares purchased over five months:
- Month 1 = 10
- Month 2 = 20
- Month 3 = 100
- Month 4 = 20
- Month 5 = 10
- Total Purchased = 160
Here’s her value after five months:
- 160 shares x $10.00 per share = $1,600.00
She invested $500 (only half what her stupid husband did) and it grew to $1,600 which is $1,100 more than poor Mr. Investor was able to do during the same period of time with a lump sum investment.
Does it always work this way?
No, it does not. If the mutual fund would have started going up on day one and continued for a long time … Mr. Investor would have been better off than Mrs. Investor. That’s a fact we cannot ignore.
But the point I am trying to make is …
Just because an investment in a fund, an ETF or stock goes down in value for a period of time is no reason to sell out and run from it as fast as you can … especially if it is a company that is large, has a lot of shares being traded (meaning it is liquid) and the company has a history of trending up for longer periods of time than it does down.
Facebook is a good example to look at – even though I stated I don’t like the “politics” of the company at the present time.
10-year lookback on Facebook (Weekly):
The following chart is a weekly chart of Facebook stock for the past 10 years. I’ve added X’s on drawdowns where a person could consider investing more money.
Facebook is purely a growth company that does not pay any dividends and to my knowledge has not had any splits since it went public on May 18, 2012 at $38 per share.
Here’s the purchase prices at the day’s closing value:
- May 18, 2012 = $38.23
- Sep 4, 2012 = $18.98
- Jun 3, 2013 = $23.29
- Mar 31, 2014 = $56.75
- Jan 11, 2016 = $94.97
- Dec 27, 2016 = $115.05
- Apr 2, 2018 = $157.20
- Dec 17, 2018 = $124.95
- Mar 16, 2020 = $149.73
- Sep 14, 2020 = $252.53
- Jan 11, 2021 = $251.36
- Oct 18, 2021 = $324.61
- Nov 29, 2021 = $306.84
- Feb 9, 2022 = $229.88
Now assume a person had $70,000 to invest and invested it all on May 18, 2012. He would purchase about 1,831 shares. Those shares today would be worth $424,902. Not bad … a gain of about $354,903 in 9 years and 9 months or so. That would be a return of 507.01% or an average of about 52% per year simple return. The average compounded rate of return would be 20.32% per year compounded annually. Take a look at the three graphics below:
What would have happened if a person simply invested $5,000 at the X’s placed on the chart earlier? Take a look:
Here we end up with slightly less invested $68,817.56 as compared to $69,999.13. However, the end result would be less $228,002.64 as compared to the lumpsum investment ending with a value of $424,902.04 – which is a lot more in dollars.
The key here is that we did not have to lay out all $70,000 at one time in hopes of a decent return. We were able to buy the dips and still end up with a reasonable return of 231.31% over the 9-year 9-month period of time. It is almost impossible to get a “compounding rate of return” with on going investments, but a person could put a spreadsheet together on a program like Microsoft’s Excel and come up with an “Internal Rate of Return.”
When I put the cash flows on a spreadsheet as monthly cash flows (and not daily, which would have taken too long – but been more accurate) I came up with a monthly internal rate of return of 1.774%. This would be equivalent to an annual rate of return of about 21.288% per year which is not that much different than the compounded annual return on the Lump Sum investment of $70,000 at 20.32% per year.
The point is that all the money is not working all the time on the sporadic dollar cost average investment (only the first partial investment works all the time and the last was only there a couple of hours) … whereas with the Lump Sum investment $69,999.13 was invested for the full period of time.
In fact, if I do the exact same calculation with the initial investment of $69,999.13 ending in a value after 122 months, we get an internal rate of return (IRR) of 1.502% per month (or 18.024% per year). So, even though you would have ended up with more money at the end … the return was actually lower since all the money was invested at one time for the entire period rather than on-going investments.
The basic idea should be clear …
If you have an investment, you like and continue to have faith in, there is nothing wrong with investing more money in it when the price declines. Rather than buy on every decline, you may set a target decline. For example: If the price declines by at least 20% or 30% from its previous high. You could do this by setting up “Alerts” in the brokerage platform that you happen to be using.
Let’s say I own Microsoft (MSFT) that I bought on 09/16/2021 at a price of $304 per share, and I was willing to buy more at a 20% discount if it occurred. I might put in an alert that states if it drops to $243.20 per share to buy more. While it dropped on 09/30/2021 to $281.62 it did not hit my target of $243.21 so I would not buy it.
If I look on my price chart (and you should check these daily on all holdings) and see it hit a high of $345.10 on 11/22/2021 … I may change my alert to say if it falls 15% to $293.34 to buy more. As you can see in the chart below it actually hit a low of $276.05 (shown in the candle chart) on 01/24/22 and actually closed at a low of $288.49 on the following day. So, I would have likely purchased more shares on one of those dates.
To be able to Dollar Cost Average effectively you really need three things …
- A plan to know when to invest (and this plan should be written),
- Patience to wait on the market to make your move, and
- Money on the sidelines or other stocks/Funds/ETFs that you are willing to sell when it comes time to make the move.
I do hope you get as much out of reading this article as I did in writing it. If I can answer any questions, please leave them in the comment section below and I will answer those that I can or direct you to a place to find your answers if I can’t – and I don’t have all the answers, for sure.
Thanks for reading …
Jerry Nix | Freewavemaker, LLC