Dollar-cost Averaging: Not Always a Good Decision

Dollar-cost averaging is an investing technique used to accumulate shares of stock over many month or years. Typically buy-and-hold investors use dollar-cost averaging in retirement accounts and dividend reinvestment plans. A specified amount of money ("dollars") is used to buy shares at a regular interval, say each month, and then the stock is held for the long term. When you invest money by payroll deductions or automatic debits from a bank account for systematic stock purchases you are dollar-cost averaging. As the stock price moves up, a specified dollar amount purchases fewer shares but when the stock price moves down, it obviously buys more shares. Therefore, the average price per share is computed using the purchase price for many purchases.

For example, if you spend $100 to buy two shares at $50 per share and then spend $100 to buy four shares at $25 per share, the average cost is $33.33, which is the total paid ($200) divided by the total number of shares (6). If you buy one additional share at $100/share, you own seven shares at a total cost of $300. Therefore, the average cost is $42.855 ($300/7).

Here are three examples of dollar-cost averaging. Pfizer (PFE), the large pharmaceutical company, shows how dollar-cost averaging ensured huge profits as its stock price increased for many years. Dollar-cost averaging for Lucent Technologies' (LU) shareholders proved to be a disaster after its stock price collapsed. Dollar-cost averaging for a cyclical stock like Kulicke & Soffa (KLIC ) gave investors gyrating up and down returns.

For each example the investor spent $100 per month to purchase stock, which was held for the long run. The charts show the monthly dollar value of the investments.

3M (MMM) investors, who started dollar-cost averaging purchases of $100 per month in January 1976, realized a peak value of $427,658 in June 2004 for a $34,200 investment. As of February 13, 2006 the value was $359,106 for a $36,200 investment.

These returns resulted from a systematic long-term investment plan that coincided with an increasing stock price. Clearly, dollar-cost averaging made enormous sums of money for these 3M shareholders.

Long-term investing in Pfizer proved to be a winning strategy, but long-term investing in Lucent Technologies (LU), a large telecommunications equipment supplier, was a disaster. The LU chart shows the value of a $100 monthly dollar-cost averaging investment plan started in 1996. The dollar value peaked at $17,069 in December 1999, the peak of the stock price. But the value of the investment plan collapsed along with the stock price. A $8,300 investment was worth $1,816 in February 2003, a 78% loss.

Dollar-cost averaging failed to overcome the precipitous decline in Lucent's stock price. Systematic buying at ever-lower prices could not offset the slide in prices. It's difficult to make money when you buy on the downside using any strategy, and systematic long-term dollar-cost averaging ensures you buy on the downside of a collapsing stock price. In these circumstances, dollar-cost averaging is not a prudent investment strategy.

Kulicke & Soffa (KLIC) is in a cyclical business that makes equipment for microchip manufacturers like Intel (INTC) and International Business Machines (IBM). Therefore, the stock price and corresponding values of the dollar-cost averaging plan follow the ups and downs of the semiconductor industry.

The KLIC chart shows the dollar values for a $100 per month investment schedule started in 1990. For each of the four cycles, the peak of the plan values coincided with the peak of Kulicke & Soffa's stock price. The March 2000 peak value was $123,127 for a $12,100 investment, a 918% return. Long-term investors, who want to cash out of the plan, should do so when the plan is at high values, when prices are high. If you stay with the cycle, your proceeds can decline dramatically. For example, if you sold in February 2003, the proceeds were $18,300 for a $15,600 investment, only a 17.3 percent return.

Clearly, dollar-cost averaging produces large profits when stock prices rise for long periods. But when prices decline for long periods, dollar-cost averaging leads to small investment returns or even losses for buy-and-hold investors. For cyclical stock prices, investors must cash out at or near peak prices to realize maximum profits. Use CTM to spot peaks and bottoms.

Another technique employing dollar-cost averaging is "averaging down". Often, a recently-purchased stock declines within days or weeks. What should you do - buy more stock, hold or sell? This is a difficult decision. If you think the decline is temporary, you can simply hold the stock and wait for it to resume its up trend. Or you can buy more stock at a lower price than the original purchase price. This is averaging down. You buy more at a lower price and then average the cost of the two purchases to lower the break-even price. The third option is to sell the stock and take a loss.

If you decide to average down, and the stock rebounds above the second purchase price, you're in good, or at least better, shape because you own more shares at a lower break-even price. Therefore, your potential gain is more than if you didn't average down. However, if you average down and the price continues to drop, you have lowered your break-even price but as the stock drops you lose more money because you have more shares. In the first case you bought on the upside and in the second you bought on the downside.

The three-year chart of Sun Microsystems (SUNW), a leading computer manufacturer, shows averaging down during a long-term upside.

Assume you bought 100 shares at $48 on March 23, 2000, which was near an intermediate top of over $50. The stock then declined and you decided to average down so you bought another 100 shares at $40 on May 30, 2000 making the break-even price $44. After the second purchase, the price climbed to over $60 and then began to decline. The horizontal break even line shows you were making money, except for a few days, from early June to mid November.

Averaging Down on the Downside

Assume you bought 100 shares at $48 on November 9, 2000 and another 100 shares at $40 on November 22, 2000. Then the stock fell and briefly rebounded to over $44 so you had only three days in December 2000 to sell above $44. If you missed this opportunity, you kept losing money as the price continued to fall. Averaging down did not overcome the rapid price decline.

What can we conclude about averaging down? Averaging down lowers the break-even price and gives you larger potential profits and a longer time to realize them if you buy on the upside.

If you average down on the downside, you may have a brief opportunity to break even or make a small profit. However, if you miss this chance, you will sustain losses until the stock bottoms and enters a new up trend, which may or may not happen. Therefore, avoid buying on the downside.

Averaging Up

Assume you pay $40/share for 100 shares of a stock that is on the upside. After you purchase the stock, its price keeps going up. You like the company and want to own more shares so you buy 100 additional shares at $50/share. In this example, you own 200 shares at an average cost of $45/share, a greater price-per-share than the original 100 shares. Thus, you averaged up. Averaging up works as long as the price keeps going up, so you can sell at a price greater than the average cost/share. To protect your profits you want to sell on the upside or shortly after prices have peaked. Obviously averaging up on the downside makes no sense.

Conclusions and Recommendations

Be careful with dollar-cost averaging. It works when prices are on the upside. But if you make repeated purchases on the downside and prices keep falling, you will lose money. Be particularly cautious with individual stocks of poorly-managed companies or stocks whose prices have increased rapidly. These stocks can quickly decline from very high prices to very low prices. For cyclical stocks take your profits when prices are high.