The onset of the COVID-19 pandemic has brought heightened awareness to some basic health and sanitary routines. How many times in the past 2 months have you heard a health expert say ‘wash your hands and avoid touching your face or rubbing your eyes’? These are things that we should do every single day, but when the potential consequences of ignoring these guidelines become more serious and immediate, all of the sudden the compliance rates increase dramatically.
Financial health also has its share of common wisdom that is likely getting more attention in the current volatile market.
To name just a few phrases of financial wisdom that you have surely heard many times:
- Make sure you have a “rainy day” fund
- Keep an eye on your expenses
- Stay the course during periods of volatility. Resist the urge to time the market.
- Buy Low, Sell High
I’d like to focus on #3 from this list and a tried and true strategy that serves as a way to implement it.
Market timing is a loser’s game:
Every single investor on the planet (past and current) has a strong desire to buy into the market at the “right time”. As an example, if you had the option to put your first sizable chunk of money into the stock market on either September 10th, 2001, one day before the World Trade Center tragedy changed the world as we knew it, or a few weeks after the tragedy and the subsequent drop in the market, which would you choose? Any rational investor would want to put their money in after the market decline.
The challenge with this hypothetical is we don’t have a crystal ball that tells us in advance of any news, events, or data that enable us to choose the “right time” to either put our money in or to take it out.
Even ignoring for major events like 9/11 or the current COVID-19 pandemic, a lot of investors feel like they know the near-term direction of the market and economy and base their investment decisions accordingly. Last month saw nothing but downright awful news regarding unemployment claims, economic growth (or lack thereof), and general uncertainty on how things would get back to “normal”. If there’s one thing the market hates, it’s uncertainty.
In many respects it would be considered a very rational position to say something like “the unemployment numbers are going to be historically awful and the market will react negatively to them…I’ll wait until after that to put my money back in”. So, what were the final results for April? It was the best month for the market since 1987! Up close to 13%. In isolation, this makes absolutely no sense and suggests that the market isn’t being driven by rational decisions. Adding the context of the precipitous market drop in the 2 preceding months makes April’s results less surprising but definitely not something that was widely expected.
“In the short-run, the market a voting machine, but in the long-run, the market is a weighing machine.”
Every trading day, investors “cast their votes” by buying and selling securities. These votes can be based on any number of reasons, many times driven more by emotion than intellect. A scale has no subjectivity whatsoever. On a long-term basis, the market evaluates companies based on earnings and other key metrics and values the stock accordingly.
OK…you convinced me that I can’t predict what the market or economy will do over the short-term and even if I could, I can’t predict how the market will react. So, how should I approach investing given the current uncertainty and volatility?
Dollar cost averaging: A financial equivalent to “Wash your hands!”
DCA is one of those concepts that sounds so simple that many people downplay how powerful it can be to their investment results. Everyone wants to buy low and sell high and that’s why the incentive to try to time the market is so alluring. While DCA doesn’t guarantee that you will get your shares at the lowest price, it does rule out the extreme cases, both good and bad.
In plain English, dollar-cost averaging means to invest a fixed $ amount on a set interval (i.e. monthly, quarterly) rather than making subjective and varying decisions on the timing and amount of your contributions.
In order to apply the theory of DCA to some real-world scenarios that you may be facing in the near-term, we have the 2 following scenarios:
#1 Dollar-cost average your way IN: This could be a new investor who is nervous about starting their investment program or someone that has received a large chunk of cash (annual bonus, inheritance, etc).
#2 Dollar-cost average your way OUT: This could be someone getting closer to retirement who wants to reduce their exposure to stocks or perhaps an investor with a concentrated position in one stock (i.e. all those RSU’s have built up over time) looking to reposition their portfolio. The bottom line is, you recognize that change is needed, but you're unsure how or when to make the necessary changes.
Whether you are truly entering or exiting the stock market or you simply need to restructure your stock holding for better diversification, the point is how can DCA help you get from Point A to Point B?
- Cash bonus: It’s always a good day when a lump sum of cash drops into your account. But now what?
A. Do Nothing: I put this one first intentionally because this is the proper sequence on the decision tree. Before you login to your brokerage account and start typing in tickers, you need to first answer a few questions. Do I need this cash to pay down debts, to go toward a down payment on a home, or to replenish the cash reserve which has been depleted since the last bonus or batch of RSU’s? If you can safely say I don’t need this cash and can afford to invest it for at least 5 years (and hopefully much longer), that’s great news and it also means you shouldn’t leave this money sitting in cash. Advance to choice B.
B. Fully invest immediately: You have been anticipating this bonus and have made plans as to where you want to invest it. You move the cash to your brokerage account and place the trade or trades at the first opportunity.
C. Dollar-cost average your way to the optimal portfolio allocation: Instead of placing all of the money into the market at a time of higher volatility and uncertainty, by dollar-cost averaging or “phasing your way in”, you take emotion and market timing out of the equation, you avoid the potential of sitting on cash for too long and missing out on the eventual market recovery, and you avoid the scary scenario of putting all of the money in right before a tangible market decline. This is a happy medium between options A & B.
2. Concentrated stock: You’ve worked for the same employer for several years. Equity has been a large component of total compensation, and you haven’t done anything aside from allowing the shares to accumulate into a rather large position. So, how best to proceed?
A. Sell all of the shares in one lump sum: The good news here is you resolve the concentration risk immediately. The potential negatives are leaving the proceeds in cash for too long after you sell if you don’t have a plan to reinvest the proceeds, facing sizable capital gains taxes on the sale, and feeling rather awful if the shares increase significantly in value shortly after you sell.
B. Do nothing: The only good news here is you are abiding by a “buy and hold” strategy that experts say is a path to long-term wealth. The bad news is you obviously aren’t resolving the concentration risk and when the next batch of RSU’s or ESPP post, the situation gets worse. If you don't see any potential problems with a large pile of company shares building up, click HERE. If we agree that we have a problem here, doing nothing comes off the list immediately.
C. Dollar Cost Average you way out of the situation: This would mean that you define a set schedule (i.e sell 20% of my current $500k position on the first trading day of the next 5 months) and you follow through and systematically liquidate the position down by $100k each month regardless of how the market moves up or down in the meantime. The final sale will be something other than $100k based on market movement over the course of the 5 months.
The Benefits of Dollar Cost Averaging (regardless of the specific situation to which it is applied):
- Lower Average Cost Per Share: You buy more shares when prices are down and less shares when prices are up. Easy peasy lemon squeezy.
- Less Price “Anchoring”: The investor who put a lump sum in at one time usually knows the price they paid. If they bought in at $100, they’re much more likely to hold onto shares in hopes of at least getting back to $100 even if their thesis for buying the shares has since changed. The DCA investor has acquired the shares at many price points and will be less impacted by this cognitive bias.
- Less stress and anxiety: There is an abundance of data showing that the pain of a loss hurts more than the pleasure of a comparable gain. If you’d like to explore this further, simply Google “loss aversion”. By implementing dollar cost averaging in a steadily increasing market, the math is simple: you would have been better off placing all of the money in at the beginning of the period. Each subsequent purchase is coming at a higher cost per share. But the ‘shame and blame’ from that scenario pales in comparison to how you are feeling if you put all the money in and the market dropped 25% shortly after. This is especially true for a new investor. The sting of that bad first impression could leave a lasting impression on behavior that negatively impacts the long-term results.
If the typical investor approached investment purchases in the same way as they do for all other purchase decisions, dollar cost averaging would actually hurt their results.
Imagine you are in the market for a new laptop. Which of the following headlines are more likely to motivate you to pull the trigger?
- Apple has just reduced the price of the MacBook Pro by 40%!!!
- Apple just released the latest MacBook Pro at the highest price point in their history.
Although the hardcore Apple fans are some of the least price conscious people on the planet, in general I think more people would jump at a 40% discount than a record high price tag.
Now shift the conversation from Apple products to Apple's stock price. Which one of these hypothetical headlines would motivate you to buy more shares?
- Apple stock down 40% as investors fear trade relations with China could impact iPhone shipments
- Apple stock hits a record high as investors embrace growth in service revenue and higher than expected watch sales
If we all behaved the same with our investment decisions as we did all other purchase decisions, we would see the 40% drop as a prime buying opportunity and load up. In reality, most investors assume the downward trend will continue and follow the crowd out the door.
The dollar-cost averaging investor does in fact load up when the price is down and position themselves to be handsomely rewarded when the shares do recover.
In summary, dollar-cost averaging is a powerful strategy that you can implement either on your own or with the help of a financial professional. The concept is very simple and the results can be powerful, but the ability to actually do it and stick to it over time is where the challenge lies.
Just like the consequences of not washing your hands have increased due to COVID-19, during periods of increased market volatility (such as today), the cost of not abiding by a consistent strategy such as DCA can be more immediate and life-altering.