Let me just say that “dollar cost averaging” is just good plain old-fashioned common sense.

Much like blood-letting.

Why blood-letting seems like a good idea

1. You feel like you’re doing something;
2. There’s blood and that seems pretty medical; and
3. Obviously, it stands to reason that if the bad is inside, you must get it out somehow.
4. So there we are.

Oh, and a little less blood makes the patient feel light-headed. Personally, I like my light-headedness to be the result of a prescribed opiate tossed back with a warm honeyed brandy – but either way, it’s better than feeling nasal congestion.

But I’ll come back to that. First:

How Dollar-Cost Averaging Works

The basic principle is that you can smooth out the overall cost of your investment by making it slowly over a period of time (eg. a year), rather than investing it all at once. Here’s an example:

1. You have $120,000 to invest.
2. You’d like to buy shares in, say, Google.
3. Only, the market price is a roller coaster.
4. You can’t possibly know whether you’re buying at a high price or buying at a low price.
5. So rather than risk everything, you should split your investment into 12 lots of $10,000, and buy $10,000 worth of Google shares on the 1st of every month for the next year.
6. Sure, you sometimes buy at a high price. But then you also occasionally buy at a low price.
7. So it all eventually averages out.

A diagram:

Basically, the goal is to invest at the average share price over the period of investment, rather than the market price* at the date that you first start investing.
*AKA the spot price

Let me then ask: what makes the average price better than the spot price?

Answer: well, nothing. Because it depends.

When is the Average Price better than the Spot Price?*
*I’m about to use “λ” to indicate loss, and “π” to indicate profit.

Two situations:

1. Where the spot price goes into free-fall

2. Where the spot price rises and then goes into free-fall.

When is the Spot Price better than Average Price?

Two situations:

1. Where the spot price does the opposite of going into free-fall.

2. Where the spot price jumps around, then rises rapidly.

What You Should Notice

Dollar-Cost Averaging is really good at limiting your losses. But it’s also really good at limiting your gains. So it sounds like the perfect sell to the loss averse (which is many of us).

However, it carries with it the delusion that there’s no bad decision – everything will just average out into a reasonable decision.

The FALLACY of it all

If you’re averaging out that Google investment, then you’re committed to the stock for 12 months. And you’ll just ignore the pitfalls and the successes because it’s all part of the game.

Which is ridiculous for a number of reasons:

1. You’ll keep backing losers.

If you keep averaging out a bad investment (like, say, Blackberry), then you’re just going to lose and lose and lose. Sure – it won’t look like you’re losing as much as the guy that invested everything in Blackberry from the start; but you’re the crazy one, because you’re continuing to put money into Blackberry shares.

2. There are better ways to do it.

If you’re going to be that loss-averse, then there’s absolutely no reason to dollar-cost average. You achieve a better result if you invest almost the full amount outright, and use the balance to buy put-options (which is basically share-price insurance). You’ve limited your downside (by buying insurance), and now you have all the fun potential upside of owning the stock from the start.

3. You’ll confuse “the power of dollar cost averaging” with “the power of savings”.

You tell everyone: “Yes, I put in place a $100 monthly debit order for that index-tracker fund, and let the power of dollar-cost averaging do its work”. No, fool. You let the power of savings do its work. If you were to dollar-cost average, you would take that $100, put $100 of it into a fixed deposit, and then do a $10 monthly debit order (yes – ten bucks, or some other less-than-100-dollars amount depending on the length of your planned investment period).

Please Note: I’m Not Arguing Against Making Further Investments in a Poorly Performing Share

I think that there is fundamental difference between these two approaches:

• The share is doing badly. If I buy the same number of shares now, then the average cost of my investment will be lower, so I won’t be doing so badly*.
  *Madness.
• I thought the share was a good investment at the higher price. Nothing has changed, really – I still think it’s a good investment. In fact, it’s a better investment because now it’s cheaper! Yes – I’ll buy more shares.

Both can have the same outcome. But the first is a blatant attempt to make yourself feel better about the earlier decision – which is a terrible starting point.

So Why Is Dollar-Cost Averaging So Popular?

It’s a feel-good strategy. Because:

1. You feel like you’re doing something;
2. There’s a strategy, and that seems pretty financial; and
3. Obviously, it stands to reason that there will be losses, and they must be limited somehow;
4. So there we are.

And even if you might not get the full benefit of a bull market – the truth is that you’ll be consoled by the fact that your investment is doing well regardless.

Of course, much like the blood-letting, there will be professionals that might say that you’re cutting yourself…

But whatevs – as long as it feels good, right?