Dollar Cost Averaging Vs Stockpiling Stocks
Should you dollar cost average or stockpile when investing in the stock market? It really depends on the time that you have to devote as well as your skills and experience.
Dollar cost averaging is the practice of buying a certain number of shares in a given stock or fund periodically. So you buy a certain dollar amount of shares regardless of the price of the shares. Typically you get your paycheck and a certain portion of that automatically goes towards buying shares. You buy more shares when prices are low and less shares when prices are high.
The benefits of this is that it reduces your risk of investing a large amount of money in a single stock at the wrong time. That being said there is a natural tendency for "dollar cost averagers" to be afraid when there is large pull back in the market due to market headlines; and only buy when things are going well and that is a mistake.
If you don't know how to analyze companies and know when things are a good deal and when they are a bad deal this protects you from making mistakes. This is similar to the principle of diversification. There is the famous quote that diversification is protection against ignorance. Diversification protects you from not knowing which companies to pick, and dollar cost averaging protects from not knowing timing.
So if you don't know too much about investing and want to get into the stock market your best bet is to buy an index fund something that mirrors the s&p 500 and make regular contributions when you get paid in both the good times and bad times and simply stay on course.
That being said if you are someone who has more time to commit to investing and to do the work to determine whether the value that you are paying for a company is good or bad. You actually want the price of a stock to go down on the piece of the company that you don't own so you can buy more shares. This is if nothing has fundamentally changed with the company. Off course in the long-run you're going to want things to go up. But temporarily it is an opportunity or a sale that you can exploit. There are opportunities all the time. It is your job as an active investor using the stockpile approach to be a truth seeker and delineate fact from fiction. You are a consumer so you want the price of the thing that you're consuming to go down.
When the price goes down below value of the company with a margin of safety you then you begin to start stock piling the stock. If it goes down some more that's great you keep buying. If it goes above value less margin of safety you stop buying.
Price and value of a business is not the same thing, and there is a tendency for stock prices to revert to their value in the long-term. You are essentially in this way looking at it the same you that you would when buying a business you look at revenue growth, free cash flows, payback period to help determine a value for a business. This valuation component is a much deeper area of study we'll discuss in future videos.
You also need to look at other factors as well such as strategic competitive advantage, total addressable market, company culture, management etc. This is how a professional will do it.
Lets look at simplified example from a quantitative perspective. Say you have a company with a value of $10.00 per share that we want to buy with the DCA method in scenario A or with the stockpile approach in scenario B with a margin of safety of 20% or $8.00. You have $10,000 to invest every year, and during the time period of our 10 year analysis nothing fundamental changes with the company . That is the key when looking at things long-term.
Furthermore, let's assume this company has 100,000 shares outstanding. Imagine now the stock now starts at $8.00 in Year one then bounces around between $8-$12. If you are dollar cost averaging you are buying in every year, and then when stock piling you are buying in Year 1, Year 4, Year 7, and Year 10. Under these assumptions at the end of Year 10 you would own 10,500 shares if you were dollar cost averaging or 12,500 shares if you were stockpiling when the company shares in the years that the company shares were selling at $8.00. Your average cost is $9.52 under DCA and then it $8.00 when stock piling. Under our assumption of 100,000 shares outstanding you now own 10.5% of the company under the dollar cost averaging method and 12.5% under the stockpiling method.
If we wait a couple years until year 12 without further contribution until the stock price rebounds to $12.00 you will have a 50% return on your money using stockpiling, versus roughly 25% when dollar cost averaging.
In my opinion DCA is not bad, but it's just there to protect you against your own ignorance of making the mistake of buying too high. If you take the time to learn about valuation and buying good businesses about the art of value of investing you can do better than DCA now doubt. Dollar cost averaging though does make sense when you don't have time for research and learning about companies. The key is you want to make sure you stay committed during market dips and keep on buying. Do no panic.
In practicality, It's also important to note than when using the stockpiling approach that when do get a dip and the company goes down say in this scenario below that $8.00 mark it doesn't mean that you should deploy your capital right away. You can still employ dollar cost averaging techniques and slowly buy your position in over months or even over a few years as the stock price dips at or below your buy target.