You are right that the one beneficial effect of DCA is that of forcing the guy getting a regular paycheck and having regular expenses to refrain from putting his money in the mattress. It does not work for the person who suffers an unusual windfall or setback in a given month or for the person who gets irregular income. That person would be well advised to invest nothing in the lean months (when he may have to borrow money!) and bundles of money in the fat months, totally disregarding DCA.
But the business about “lotsa shares” is a canard. The number of shares purchased is merely a fiction useful for bookkeeping purposes. What you do care about is that you invested $100 every month since 1980 that is now worth $1 million. Who cares how many shares you bought over the years and how many times the stock split and how many shares you now own? If the stats say that your single dollar invested in the market in 1923 grew at an APR of around 7.2% from then till now, they tell you that your 1923 dollar is now worth about 2**8 or 256 dollars (rule of 72); the number of shares you now own is irrelevant!
Yes, I agree it’s wise to invest in an index fund for a couple of reasons: fees are low and you don’t have to buy a $1.00 WSJ or go online every day to check up on the value of numerous stock holdings. Depending on the index fund, you can get all the info you need by hearing it on NPR. (Which brings up a longstanding complaint of mine: the news always reports how much an index is up or down for the day, and only sometimes reports what its value is. A Rip Van Winkle waking up and hearing the usual report would have no idea if his investments had made him a prince or pauper! But any person who knows what he paid for an index holding would know his instantaneous worth if they just reported the current value of the index and forgot the up/down nonsense. Which reminds me of another beef: The reporters like to say, “The Dow lost 100 points today on news that General Electric …” How the hell do they know what made the Dow move? Furthermore, it could well lose only 100 points on good news if the expectation was for bad news that would have cost 200 points, so that most people would conclude that what was in fact good news about GE was bad news!)
When I say that diversification confers no financial benefit, I do not rule out that it can bring a “psychic” benefit, if that’s what you’re into. It’s like placebo, praying or going to mass: it brings no objective benefit whatsoever but can put a smile on the face of the true believer who meets his soulmate at mass. Consider simple examples: I place before you two boxes, one with four nickels and the other with two dimes and two plug nickels. The sacks are indistinguishable and the contents worth the same, and you get to reach in and blindly pluck two coins from one sack or one from each sack after paying me 1 cent per sack opened (transaction costs). Would you diversify? If you do, you might win, but the chances are that you will lose, so that diversification is a bad strategy (statistically, it brings a loss).
Or put all the women in the world are in two blind sacks. You can reach in and grab your soulmate from either one or grab one from each sack and average their qualities. If you have to pay to open a bag, again you lose if you diversify.
Another example: a high-risk kind of gal goes off to climb Everest but makes sure her homeowner’s insurance is paid up. This is foolish behavior, but extremely common among Americans.
As far as investment is concerned, if you are a person who can stand only moderate risk, you are better off putting all your money in a moderate-risk index fund than you would be putting some in a high-risk fund, some in government bonds, and the rest in a savings account, because of the fees and transaction costs.
Thus I say: while diversification never brings an objective financial benefit, it always brings a loss, if there are transaction costs. This has to be understood in a statistical sense, of course.
Motley Fool apparently has it about right: if the market is efficient and you have no inside information and there are no transaction costs, every strategy is as good as any other, including that of basing your buy/sell decisions on the number of cars at the mall!
There are several ways to die broke. One is to spend your last nickel every day, as most of the world has done for eons. Another is to sell off everything and rely on a lifetime annuity, which is normally purchased from an insurance company, making it as bad a deal as insurance. Better is a private annuity that you seal with a friend, offspring, nephew or niece, who sends you a check every month and ends up with your property when you die. The best would be a vast Tontine, which unrelated folks could buy into like a mutual fund. It is so sensible that, of course, the government outlawed it a long time ago.
You say that my BHSL strategy is “really buying high and selling higher, which others have used as a mantra to sell books,” but that is not true, for a couple of reasons. Using BHSL, you would never sell if the price always went up month to month and might well sell lower if the price goes down the first month!
My spreadsheet calculations show that DCA brings the same result as BHSL and BLSH, and thus can be said to be no more or less risky than any arbitrary strategy. Diversification can certainly lower risk, both the risk of losing all and the risk of getting filthy rich, just like averaging two tosses of a die gives you a 1/36 chance of going broke (scoring 1) and a 1/36 chance of wealth (scoring 6), whereas the chances with one die are of course 1/6 for poverty or wealth. In both cases, the expected outcome is 3-1/2, so the choice between diversifying or not is a wash as far as “average return” is concerned.
In investing, rational folks concentrate on maximizing the return. Superstitious, religious and fearful folks concentrate on minimizing risk, which, in the real world always interferes with maximizing life, love and wealth. Insurance is a perfect example. The only rational behavior (unless you have inside information) is to “go bare.” It is fear and superstition that drives folks to take a expected hit as high as 80% loss (in the case of car insurance) or 40% loss (in the case of flood insurance) on every premium dollar spent. Check out the stats on the FEMA flood insurance website! Only wimps, fools and those with inside information voluntarily participate in any kind of insurance!
Diversification will indeed reduce the risk for a given return, both the risk of loss and the risk of gain. But you lose if diversification implies transaction (or information) costs. I think you need to explain how there can be a financial benefit in diversification, unless you can show that a strategy that statistically leaves you slightly less wealthy, handsome and intelligent than the person who can expect to gain his average qualities from a dart board confers a “benefit.”
I agree with you that DCA is about investing compliance, no more, no less. So why don’t they just call it something like “regular monthly investing (RMI)” instead? I suppose that the reason is that financial advisers, who have nothing to say, have to say it using magical words, otherwise the public might catch on to their less-than-worthlessness.
I don’t agree that “Number 5 is all wrong for the professional trader,” unless by “professional trader” you mean someone who can move a market or has inside information. Professional boxers, for example, statistically lose exactly as many times as they win, and when a bear is chasing you in the market, you not only have to run faster than the other guy, you have to run faster than all the other guys, because of the effect of arbitrage. It was my own cousin, along with Nobelists Merton and Scholes – professionals all – who managed to lose more than $4 billion while having upward of $2 trillion in play in the arbitrage game.
You sure are right that DCA serves to obscure cost basis, but you are wrong about the rest. Here’s what happens in other scenarios:
- Long downtrend: DCA is no better than BLSH, and both are much worse than the mattress.
- Long uptrend: DCA is no better than BHSL.
- Linear drop to half-value, followed by linear rise to full value: DCA beats BLSH, but loses to BHSL.
- Linear rise to twice-value, followed by linear fall to initial value: DCA beats BHSL, but loses to BLSH.
Of course there are scenarios innumerable, but I maintain that, unless you can see the future, DCA has no advantage over any other investment strategy (except the null strategy of the mattress).
Your analysis of what would have been the best strategy in January of 2000 doesn’t merit the wasted ink, since hindsight is of no value in investing, unless and until you can invest in the past! In any case, if you could invest in the past, diversification would NEVER be the best strategy for ANY period. And as far as Vegas is concerned, are you asserting that diversifying by placing a bet on roulette and one on blackjack is better than two bets on blackjack? There are a lot of blackjack players who can beat the expected return of around 95% for roulette. It is a truism, however, that if people were able to put their monthly social security premium on a spin of the roulette wheel instead of into the gummint Ponzi scheme and invest what’s left over with DCA, they would end up between $1 million and $2 million richer after 45 years of working life, have a lot more fun, and have something to leave their families.
Asset allocation is worse than non-diversification for the investor, but much better for the financial advisor, so I’m afraid we’ll be hearing about it, ad nauseam, for a long time to come. Inside information is traded on all the time and you probably will not get caught and not go to jail. It is not immoral and The Chicago School recommends that the criminal sanction be abolished.
The truth of my analysis of the value of DCA, compared with competing strategies, does not depend on the assumption of the random walk, but instead on the assumption that the investor has no idea what month-to-month price movements any particular stock or index will experience. Indeed, even the assumption of a long-term rise in the value of the general market is untenable, to the extent that it is based on historical data rather than a trust in the positive value of enterprise. In the absence of that trust, you are well advised to get out of the market altogether and rely instead on the mattress or instant gratification, since transaction costs will eventually eat you up.
You need to put your glasses on if you read me to say that I have found a CD that pays 7% today. As far as my BLSH strategy, you will see, once you get your glasses on, that I have defined the “high” and the “low” and any fool could use my strategy prospectively. And there must be a 12-point program to help you overcome your fixation on the number of shares a person owns.