10

It is often said that we should "Buy low, sell high". But we can't know when the market is at its low or high.

Another phrase we hear is "dollar cost averaging"

Consider:

  1. A long term young investor
  2. A long term middle age investor
  3. A person near retirement

Should people in all three categories follow the same advice?

I am asking how does "dollar cost averaging" and "Buy low, sell high" relate/differ.

  • 1
  • 13
    You're asking two completely different groups of questions. You're asking a) about DCA vs timing the market, and b) about asset mix as one approaches retirement, which is about volatility management. Perhaps you think they are related, but they aren't. . – Harper - Reinstate Monica Nov 21 at 21:48
  • 1
    I would add "4. What should a person near retirement but who won't feasibly have enough money to retire in their lifetime do?" – Michael Nov 22 at 2:43
  • @michael agree on the 4th option – mina Nov 22 at 13:34
16

Market timing vs dollar-cost averaging

This is a strategy for changing the asset mix in your portfolio. Paid brokers positively love dollar-cost averaging; because it allows them to give exactly the same advice regardless of market conditions, and always be "right" and evade responsibility for market turns, even obvious ones.

I'm not 100% thrilled with it, though, because dollar-cost averaging tells you to completely ignore the obvious: we've been in a very long bull market, and it's time to start thinking about whether this is a bubble; interest rates are very low which means certain financial products are a very bad buy; etc.

However, this is not what your question is really about.

Managing investment mixes for different ages

You may have heard the term volatility, often confused with **risk*. Volatility reflects the deviation of how much stocks will go up or down in a given time-planning period. For instance, at a 30-year planning horizon, stocks are not very volatile at all - their growth and dividends can be relied on. That's how endowments work. And believe me, they do work!

However, as the planning horizon gets shorter, volatility becomes more certain and more extreme. At a 1-year planning horizon, anything can happen. Stocks can go up 80% or down 40%.

So what does this mean? If you have 30 years til retirement, the stock market is a sure thing. You don't need to think about that choice; anything else would be a mistake.

But at 15 years til retirement, volatility starts to appear. It will probably go up a lot. But it might only go up a little, or even slip a bit.

At 5 years, volatility is in full swing. It might triple and might backslide 30%.

You can't allow yourself to be wiped out near retirement

The last thing you want is to have a 43% market turndown just at the moment you need to spend the money. That's a bit extreme, since you presumably spend the money over years of activity, so there isn't a "moment" per se, and it will average out somewhat. But if your retirement-years-of-need happen to land in a market doldrum period, like 2007-10, you could get badly hurt.

Volatility and growth go hand in hand. The price you pay for long term growth is short term volatility.

So it's a very sensible strategy to start backing out of the market as you near retirement (or to be more precise, time of withdrawal). Typically this is done by altering your asset mix, to be a few percent less stocks every year and a few percent more "less volatility, but less growth" investments like bonds. As you are in your end years, you want to be mostly in bonds or low-volatility investments - that way you aren't left flat by a sudden downturn.

If you look at 401K "horizon funds" or "target-year funds", that is exactly what they do.

To revisit "timing the market", they don't, but you could if you are paying attention and are willing to accept the risk of potential un-captured gains. (that is to say, if you move out with the Dow at 16,000, and shortly after the Dow goes to 19,000, that's money you didn't win. The flipside is if the Dow fell to 12,000, that's money you didn't lose.

  • 7
    "Even obvious ones". There are no obvious (if by obvious you mean easy to predict) market movements. If there were, investment funds would not struggle as much as they do to achieve positive alpha. And if they were obvious, they would be adjusted for before anyone that finds them obvious can do anything about it. – JBentley Nov 22 at 12:50
  • @JBentley Is it obvious that given an arbitrary point in time, the market is eventually going to go down? – Onyz Nov 22 at 16:31
  • @JBentley: Most market movements are obvious based on publicly available information. The problem is that the delay from the information becoming available and the movement is insufficient for ordinary people to act on it. – Ben Voigt Nov 22 at 17:16
  • 2
    @BenVoigt I believe that that is essentially what I said, so we are in agreement. Note that this answer implies the opposite with "evade responsibility for market turns, even obvious ones", suggesting that brokers could have correctly advised their clients about such obvious movements, but are evading responsibility for doing so. – JBentley Nov 22 at 17:51
16

Neither of these strategies apply to long-term investing. They are more applicable to day-traders or short-term investors.

"Buy low, sell high" is more of a reminder that one should not always buy things that have gotten expensive (follow the trend) and sell things when they've declined (panic sell). If you're a long-term investor, then these short-term swings won't matter to you - you're in it for the long term. It also defines a "value" strategy where investments that are seemingly "cheap" are bought and investments that are seemingly expensive are sold. But as you pointed out, it is difficult (if not impossible) to know when the market is "low" or "high".

"Dollar-Cost Averaging" is a strategy to avoid downside risk of large investments. Many people who contribute to 401(k)s or other retirement plans do this automatically by contributing periodically (e.g. twice a month, every two seeks, etc.). Outside of that, if you plan to buy a lot of something and don't want to risk a short-term decline, then you can spread out your purchases over time. If the value goes down from your initial purchase, then your average purchase price will be lower. However, if it goes up, then you'll miss out on some of the gains that you would have had if you just purchased it all at the beginning. So it's a tradeoff, reducing downside risk but risking some opportunity cost. Unless you experience a large drop between investments, DCA won't matter much.

What should a long term young investor do?

Buy now, sell later. Rebalance periodically to lock in gains for things that have grown a lot and buy more of the things that have gained less (or lost). The short term swings don't matter to a long-term investor

What should a long term middle age investor do?

Same - age is irrelevant if you have a defined investment horizon

what Should a person near retirement do?

It depends on if you have enough saved already to live off of, or if you still need to earn some more, but generally someone near retirement should rebalance their portfolio to reduce the overall risk, but not so much that their expected return is below what they'll need to earn to avoid outliving their retirement funds.

  • "Rebalance periodically to lock in gains for things that have grown a lot and buy more of the things that have gained less (or lost)." That depends whether your objective is to (1) make money, or (2) have a balanced portfolio. Buying losers that will never recover is a good way to achieve (2) but fail on (1). If you do get lucky an have a runaway success in your portfolio, the advice "keep all your eggs in one basket, but watch the basket as if your life depends on it" may be better than "sell most of the golden eggs and re-invest the money in lemons instead" – alephzero Nov 22 at 13:09
  • Investing in your 401K out of your paycheck every paycheck is NOT dollar cost averaging – Kevin Nov 22 at 17:15
  • 2
    @Kevin: Of course it is, if the dollar amount is fixed (or at least independent of investment pricing). It's involuntary DCA, vs DCA that you choose, and there's little reason to discuss the reasons to choose DCA when you have no choice. But it still is DCA. – Ben Voigt Nov 22 at 17:18
  • @BenVoigt No, dca is a strategy used when you have a large sum available to invest and have to choose between investing it all at once or spreading it out over time. If anything, investing in your 401K every paycheck is THE OPPOSITE of DCA because you are investing as much as you have available at that moment – Kevin Nov 22 at 17:25
  • 1
    @Kevin: I agree that when investing in your 401(k) every pay period, you cannot choose a strategy. You end up with DCA by default. But "dollar-cost averaging" is not a strategy, it is the statistical properties of the value of a sequence of investments made in a constant dollar amount at varying prices (so the number of shares varies inversely with price). All those statistical properties apply to periodic 401(k) investments. When you have a choice, you may strategically choose to use DCA. But the strategy is tied to having a choice, not to DCA itself. – Ben Voigt Nov 22 at 17:30

Your Answer

By clicking “Post Your Answer”, you agree to our terms of service, privacy policy and cookie policy

Not the answer you're looking for? Browse other questions tagged or ask your own question.