Money Management and the Economy

Tuesday, February 5, 2008

Media Investment Advice

CNN's Walter Upgreave today made clear why taking investment advice from the media is a bad idea. In his column today he takes a contrary view of "dollar cost averaging". The dead giveaway is this line:

"But while dollar-cost averaging has risen to the level of accepted truth in many circles, it isn’t the magic bullet it’s made out to be. Indeed, some of the claims are simply an illusion."

Put another way, his job is to provide something interesting for us to read and repeating conventional wisdom won't get you many readers. But there is a reason why dollar cost averaging is conventional wisdom and Upgreave is doing a huge disservice by encouraging people to ignore it. Sometimes conventional wisdom is wrong, but, if you really understand the role of investment mix or dollar cost averaging in risk management, you realize that Upgreave's argument has no merit. Here is the nut of his argument:

"Over the course of the year, you would have actually been investing much more conservatively than you intended when you chose a 60-40 mix. The reason is that you’re holding on to so much cash, you’re virtually guaranteeing you won’t be at your 60-40 target mix for most of the year. By moving your money a little at a time, you’re actually undermining your investing strategy."

There are several reasons this is flat out wrong. The first, is that by investing all your money in a lump sum you are increasing your risk well beyond what you intended by a 60-40 investment mix. This is because you are taking on the risk of daily/weekly/monthly fluctuations in the market compared to a similar investment dollar-cost averaged. In essence, he is encouraging you to make a short term investment in the stock market.

One way to look at this is to take your lump sum and divide into four installments. That is what you do with dollar cost averaging. The next question is what should you do with the money in the mean time until you need it? Upgreave is, in essence, suggesting you invest it in stock and bonds using the same 60-40 mix that you had settled on for your long term investment strategy. But the 60-40 mix that is appropriate for money you will not need for at least 10 years, is not appropriate for money you will spend on stock three month from now.

To get an idea of how this works take a couple scenarios this year:

Lets assume you got a tax refund of $1200 on June 1st, 2007 and invested it in Vanguard's Balanced Index fund which gives you that 60-40 mix. The fund's shares were at 22.54 that day so you would have purchased 53.24 shares. Three months later, on September 4th that same $1200 would have bought 54.15 shares. By December 4th is would buy 53.98 shares.

At the end of 2007 those 53.24 shares were worth $1172. The 54.15 shares were worth $1192. and the 53.98 shares were worth $1188. By February 4th, 2008 that $1200 would buy 56 shares. Those same shares would have cost $1262 in June.

Having saved your money in a conservative cash account, you would be buying low. Having spent all your money in June - you would still own just 53.24 shares.

But why stop now? What happens when shares have reached $40 per share? That investment from June is worth 2121, if the investment was made in September it is worth 2166. The December investment is worth 2159. The February investment is worth 2240. If you invested the money in four installments, you made $50 more than you would have if you had invested int all in May and those net losses will continue to grow right along with the price of your shares.

Of course, the opposite could have happened. The market might have gone up. On average, that is more likely to happen. But if you don't cost average, you aren't playing the averages. You are timing the market whether deliberately or not. You may happen to get lucky and buy when the market is low. If you are very unlucky, and buy when the market is high. But avoiding that kind of high risk, is exactly the reason for having a relatively conservative 60-40 mix of stocks and bonds to begin with.

There is no doubt that leaving your money in cash is more conservative than investing it in the market. Bonds are more conservative than stocks. That is a the reason why investment horizon is important in determining your mix of cash, stocks and bonds. In the long run, stocks, on average, will give you the best returns. But, as the saying goes, in the long run we are all dead.

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