Debunking Dollar Cost Averaging

Great Debates
41

Generally good advice.

You can always invest it. There are plans that let you invest as little as a few hundred dollars a month or less.

Depending on the term of your investment. And I still don’y know if I buy this advice. 5% guaranteed over 30 years is always better than 20% that never materializes.

Not true. Diversification mitigates risk. In general, over the long term the stock market increases in value so your “dice” is automatically skewed towards the higher numbers. Rolling multiple dice helps keep you from crapping out if one investment goes bad.

As long as you don’t get caught, Martha.

Duh.

True. Many people forget about the whole taxes thing.

Fine advice if you
a) never want to own a home
b) want to work until you are 85
c) never plan to have kids or
d) never send those kids to college

[/quote]

Sounds like you’re on your way. Seriously though, the problem is that you don’t know when you are going to die. It would be nice to be able to retire with somewhat of a nest egg. On the other hand, that $1M in the bank won’t do you any good if you get hit by a bus tomorrow.

42

Insurance is not about saving money. Insurance is not investment, it does provide benefits in risk diversification at a small known cost - the premium. It is very very rational, and you are already either very wealthy or can live of someone else, and/or have no physical assets or dependents if you carry no insurance. Being uninsured is not a route to wealth for the individual.

No. His long term average loss may be $1300 but his loss is a function of severity and frequency. He could lose his house tomorrow, sell his investments and repair it and lose it again the next week in another 100 year storm. There is no guaranteed hundred year gap between 100 year storms! Of course you should not insure low severity (relative to you) losses, agreed.

So what? This is crazy thinking or at least totally irrelevent - again for any individual. A result “on average” is useless if he is unexpectedly flooded out tomorrow. You cannot analysis the result at the end of the period. “Events dear boy, events” - if he is flooded out bang goes all his stake money if he actually wants to live somewhere. Insurance is all about indemnity - putting you back in the position you were in before your loss.

I do not understand your point here. You are talking about two different things here. This describes me well, I rock climb and winter mountaineer and parachute but have life cover and disability cover etc. If I die or disable myself my dependent are paid, or we have a lump sum and a replacement income if I can never work again. How is this irrational or schizophrenic? Insurance does not reduce your loss it reduces the consequences of suffering a loss.

By the law of large numbers of course you are correct. But viewed from the perspective of an individual buyer you are totally wrong. What about the young guy starting out whose house burns down the day after he completed the purchase and furnishing, or the family of the young family man killed in the car crash carrying a good deal of life (death) cover. The insurance company earn a profit for selling and managing a service that provides utility.

No, this totally wrong. Hopefully I have said enough above to convince.

I am sorry if everybody decided that this DID belong in another thread. I take it as an insight to you thinking that I can extropolate to the main investment focus - where I do feel I can add much to what has already been said.

As a professional corporate risk manager though, I can tell you that you are simply plumb crazy, or rather very confused, when you write the above guff.

And if you are hold such strange and irrational views on insurance then I too would not take one bean of your advice on other financial topics.

43

That’s why you diversify.

44

I’m rather concerned by the revelation that you apparently don’t take out motor insurance. Motor insurance contains a liability element, which is to say that it isn’t all about preventing you from suffering, it’s more importantly about preventing other people from suffering as a result of your actions.

I’ll take a wild stab in the dark that you don’t have the $1m necessary to compensate a family whose two breadwinners you maim for life. The insurer does. So nice civic duty that you’re showing there.

But that’s rather by-the-by. There are many misconceptions that you seem to hold in this thread. Insurance is a nice example but notquitekarpov just dealt with that. So let’s go back to diversification.

Scylla went through this already but it was in the middle of a rather long post and easily missed. You seem to be under the misapprehension that by diversifying, you are reducing expected return. Nothing could be further from the truth. By diversifying, you are seeking to maintain expected return but reduce variability.

There are two types of risk: specific and systematic. Specific risk is the risk you get by rolling dice. If you roll one die then there is a one-in-six chance that you’ll get a 1 (minimum return) and a one-in-six chance that you’ll get a 6 (maximum return). However, if you roll 6 million dice then you can be pretty certain that you’ll get one million minimum returns and one million maximum returns, subject to relatively narrow bands.

Investing is analogous to paying $3 for the die roll. You expect to make $3.50 and hence a profit of $0.50 but with one die the spread is many times the payoff. But if you manage to spread that $3 over millions of identical investments then your profit will be almost exactly $0.50 every time. So the expected return doesn’t change, only the variability around that expected return.

The other type of risk, systematic risk, is the risk that is inherent and cannot be removed by repeating the investment.

For example in manufacturing, the systematic risk is that there is something inherently wrong with your manufacturing process that tanks everything you make whilst specific risk is the risk that one individual item is crapped up.

Because systematic risk cannot be diversified away, investors expect compensation for taking it. It is systematic risk and only systematic risk that drives yield. This means that if you are taking diversifiable risk then you are doing so without being paid for it. There is no return given as reward for diversifiable risk.

You want to target a 3% return? Find the systematic risks that reward you with 3% and diversify to remove the specific project risk. You want to target a 40% return? Find the rather more systematically risky projects that reward you with 40%… but you still need to diversify away the specific risk. In general terms, you can target any damn level of risk/reward payoff you want but if you aren’t diversifying away that part of the risk that can be removed then you’re in the position of an insurer who isn’t getting any premium for the risk they are taking.

This is the underlying problem behind all of your analysis. You already admit that if returns in the marketplace are 7%, for example, there is no expected return advantage from following one strategy rather than another. But if this is the case, a guaranteed 7% must be better than one that may yield nothing or may also yield 14%. The “must” comes in because if you are happy with the volatility inherent in the 0-14% spread, you will be able to obtain a higher expected return for that same risk elsewhere, assuming an efficient market. CAPM shows us why this is so.

Modern investment theory – and I’m not talking here about share choice, I’m talking about serious capital investment – is all about understanding the nature of risk and return. Without that in your toolbox then you’re dead in the water.

pan

45

jimbino, I think you’re wrong about insurance being a “scam” for most people. Insurance is unwise for some people, but for most people it’s a pretty good deal.

Let’s take your example of a guy who ows a $130,000 house in a 100 year flood plain. The expected cost of losses caused by a flood is $1300 a year, but insurance costs $2000 a year.

You analyze this as the guy essentially taking $700 each year and throwing it right down the toilet.

However, ignoring other things like the fact that the guy’s lender forces him to buy the insurance, what the guy is getting for the extra $700 a year is another person that is ready to pay $130,000 to replace his house at a moment’s notice.

If the guy has sufficient assets that a $130,000 hit wouldn’t affect him more than he can stand, then insurance is stupid for the guy and he shouldn’t buy it (if he’s not forced to). For people without $130,000 that they can do without at a moment’s notice, then insurance is a good thing.

46

KidCharlemagne,

quote:

“The “this” I was referring to is the notion that traders with statistically significant returns are merely anomalies.”

If you toss enough dice, there is a finite chance that one die will consistently outperform the market (average). This does not mean that the die has any intelligence whatsoever, but if it did publish a book, I’m sure you would buy it! Neither your contention nor mine is susceptible to experimental proof, unfortunately. I cannot prove that a particular die lacks intelligence.

Pleonast,

quote:

“Can you present a cogent arguments for your investment principles? Specifically, why is cost-dollar-averaging a poor investment strategy? Running a spreadsheet does not constitute a sound mathematical argument. Why should I put faith in your expectations of the different strategies versus the expectations of well-known economists?”

I thought I did present an argument, though I think that anyone who favors DCA over other strategies has the burden of proving it, which has not been done, at least on this thread. Furthermore, one of my points is that you should not put faith in what I or any other economist says. Faith is for superstitious people. Scientists, including economic scientists, do not place any credence in faith whatsoever. To the extent that they do, they are not scientists, but believers.

msmith537,

quote:

“Not true. Diversification mitigates risk. In general, over the long term the stock market increases in value so your ‘dice’ is [sic] automatically skewed towards the higher numbers. Rolling multiple dice helps keep you from crapping out if one investment goes bad.”

and kabbes,

quote:

“Scylla went through this already but it was in the middle of a rather long post and easily missed. You seem to be under the misapprehension that by diversifying, you are reducing expected return. Nothing could be further from the truth. By diversifying, you are seeking to maintain expected return but reduce variability.”

Here the two of you are flogging the old dead horse again. This message board is not a rosary and repeating the old canards won’t get you anywhere. I have already affirmed that diversification mitigates risk. Risk avoidance is NOT the proper goal of a person who invests to maximize his wealth. In the real world, diversification carries added information and transaction costs, so that its financially senseless risk mitigation implies a financially senseless reduction in expected return on investment.

Risk management is a religious pursuit: it is for folks who lack enterprise, or are fearful, wimpy or superstitious. Folks who start their own small businesses are not acting to minimize risk, for example. They often take great risk, canceling all insurance policies and mortgaging their homes to the hilt. They are not wimps and they are doing the opposite of diversifying.

“Life is trouble – only death is not. To be alive, you must undo your belt and look for trouble” – Zorba

notquitekarpov,

quote:

“Insurance is not about saving money. Insurance is not investment, it does provide benefits in risk diversification at a small known cost - the premium. It is very very rational, and you are already either very wealthy or can live of someone else, and/or have no physical assets or dependents if you carry no insurance. Being uninsured is not a route to wealth for the individual.”

I agree that insurance is not about saving money or investment. What it is about is pouring good money down a rat-hole. I think I presented good evidence that going bare (as the majority of gynecologists in Florida are now doing wrt malpractice insurance) is a route to wealth. I showed how not carrying flood insurance statistically increases your wealth over $200,000 and not carrying health insurance stastically increases your wealth over $2 million. Not participating in social security would also increase your wealth over $2 million. The person who insures is taking bread and educational opportunity from himself and his family and so insurance should be considered a form of child abuse.

kabbes,

quote:

“I’m rather concerned by the revelation that you apparently don’t take out motor insurance. Motor insurance contains a liability element, which is to say that it isn’t all about preventing you from suffering, it’s more importantly about preventing other people from suffering as a result of your actions. I’ll take a wild stab in the dark that you don’t have the $1m necessary to compensate a family whose two breadwinners you maim for life. The insurer does. So nice civic duty that you’re showing there.”

You have several cockpit problems here. Of course I don’t take out motor insurance. But the minimum liability requirement in most states is around $50,000 per accident, so your idea that an injured person can expect to be compensated to the tune of $1M by an insurance company is absurd. I don’t know where you live, but you had better worry about driving in NH, WI, TN, most foreign countries and in El Paso, where, regardless of the TX compulsory insurance, some 45% of the drivers are too smart to submit to insurance nonsense! The other thing is that I could shoot you. Do you think I would have insurance to cover that, too? Ha! Do you have it?

TaxGuy,

quote (on the insurance topic):

“However, ignoring other things like the fact that the guy’s lender forces him to buy the insurance, what the guy is getting for the extra $700 a year is another person that is ready to pay $130,000 to replace his house at a moment’s notice. If the guy has sufficient assets that a $130,000 hit wouldn’t affect him more than he can stand, then insurance is stupid for the guy and he shouldn’t buy it (if he’s not forced to). For people without $130,000 that they can do without at a moment’s notice, then insurance is a good thing.”

This is a circular argument. The poor guy buying flood insurance is in that fix because he needs a mortgage to be able to afford the $130,000 house in the flood plain. He needs the mortgage because he doesn’t have the money to cover the purchase price himself. He can’t cover the purchase price himself because he has always kept himself poor by pouring a significant part of his earnings down the rat-hole of insurance. Bill Gates, Ted Turner, IBM, the gynecologists of Florida and I don’t carry insurance because we are smart and have lived within our means. Now we have the money to take care of our own losses. It is another case of the smart and frugal becoming rich and the rich becoming richer. But consider the birds of the air, the beasts of the field and most of the world’s human denizens. They are very poor and would certainly be much poorer if they subscribed to the religion of insurance!

47

Jimbino:

Actually, risk avoidance is the proper goal of a person looking to maximize his wealth. But neither kabbes nor are talking about generalized risk. We are talking about a certain kind of risk. This is the kind of risk you don’t get paid for taking.

What you’re suggesting is playing Russian Roullette for fun. It’s stupid. We even have a joke about it. There’s something called “The risk free return,” that’s used as a baseling in Modern Portfolio Theory.

On the other hand there are people who take cosmically idiotic risks that have no chance of paying off. We call such moves “return free risk.”

Adding risk without reward is simply stupid. I am not calling you stupid, but I am telling you in no uncertain terms that what you are advocating is perfectly idiotic.

Clearly you are cognizant of transaction costs, so I’m sure you understand the concept of getting the most for your money.

Similarly any child can understand the basic concept of trying to get the most return for the risk they are taking.

Risk is not bad. Unnecessary risk is.

In the “real world” of which I am a part wealthy and succesful risk takers understand that they want to minimize risks while maximizing returns.

Diversification does not necessarily entail added costs in terms of transaction fees. It does require more costs in terms of information. Information doesn’t necessarily cost money, and I see no virtue whatsoever in being poorly informed.

Several ways around transaction costs include buying mutual funds from the same family. In many cases there are no added costs for diversification because you pay a fixed percentage of the assets you invest. There is no reason not to diversify.

Another way that is even cheaper in the long run is to buy UITs or Select Sector Spiders, or other baskets of stocks that trade as single units. Transaction costs are identical to buying single stocks.

Personally, I tend to buy individual equities, because transaction fees for me are de minimus compared to the duration and the expected return of the position.

Now, I know lots of people that take risks. I and others I know and work with take risks. Sometimes I take huge risks. The difference between a fool and a wise investor is using discrimination to be sure that those risks are both justified and necessary.

If I were to attempt to explain to a board of directors that only pussies worry about risk, they would devour me on the spot.

Speak not to me of the real world. I am there. This is what I do.

The word you are actually looking for is “experienced.” No professional takes imprudent risks.

I’m really not interested in people that start small businesses per se. Anybody can start something. The people that are actually interesting are the people that succeed.

The people that succeed tend to be demonic about maximizing return for risk. It’s a competitive world. If you want to succeed, you don’t give away advantages that you don’t have to.

The more doors to ruin that you leave wide open the likelier it is that Ruin will walk through one of those doors.

48

All you are doing is restating your beliefs. You provide no counter-agruements to my contention that you are talking out of your hat.

You have not showed not carrying flood insurance is a good thing and you totally ignore the risk you get wiped out by an uninsured loss tomorrow. Your last sentence is disgraceful but increasingly typical of your responses. You provide no elaboration to your acts of faith or counter the come back I gave you.

I conclude you are full of shit and simply do not know what you are talking about.

49

I’m afraid, jimbino, that you are really revealing your true colours now. Rather than taking the opportunity to expolore the difference between systematic and specific risk and the implications thereof, you have chosen to simply repeat your mantra of “risk good”. There’s no point debating somebody who ignores all the salient points to reply to the thing they think they can repeat their slogan at.

I repeat: what you are advocating is that it is better to have a 50/50 chance of winning all and losing all than it is to have certainty of gaining the exact same expected payoff. This is madness. Personally, I’ll take the free money any day. There is only a point to taking a risk if there is a utility reward for doing so.

And you don’t want to mess with me as regards insurance. On motor liability, let’s just say that the biggest ever motor liability loss in this country occurred a couple of years ago when a guy accidentally drove onto a railway line. He got out in time but his car derailed a freight train into the path of a passenger train.

In terms of compensation for loss of life/injury, business interruption from the train service being down and the cost of two trains, the running total currently stands at something approaching $100m. I doubt you have that kind of money.

And to re-emphasise, this actually happened (do a search for “Selby train crash”). We’re not in your strange in-jims-head world now, but the real one. And there are plenty more examples less extreme but still disastrous for the individual. Other accidents that regularly exceed $500k include motorway pileups, for example. More than half your insurance premium pays for the cost of such liability.

If you don’t want to pay for the cost of suffient capital to cover such liabilities, you shouldn’t be allowed on the road.

pan

50

Of course it is. But dollar averaging an diversifying are entirely independent of each other.

It seems to me that maximum gain comes from getting on what turns out to be a winner and concentrating on that. Examples would be Henry Ford and Bill Gates. That would also be maximum risk because all of your eggs are in one basket, which is another old adage.

51

kabbes

You aren’t saying what I think your saying, are you? You really think that people should be required to have $100M worth of liability coverage? I don’t think most companies even offer that.

David Simmons

That’s not entirely true. DCA is a sort of diversification, but across time rather than firms.

52

The Ryan - I think the misunderstanding is that kabbes was using the Selby Rail Crash in the UK as the example. In the UK the policy limit of liability of the third party liability element in motor insurance is unlimited so effectively we do have a US$100m plus of cover. It was a perfectly valid example.

The structure of the auto insurance market in the USA is different I know but the principle that you should carry a minimum amount of third party liability cover is valid for reasons of public interest as well as prudent anyway for any but the very rich. The amount needs to be a balance of course where you charge for every $ of limit…

53

As a matter of principle, I think that regulation should state that people must have sufficient insurance to cover their public liability when driving. Driving is a risky business and the consequences of getting it wrong are severe. If the potential liability in your jurisdiction is unlimited then the insurers should be forced to offer unlimited liability cover.

This isn’t as bad as it sounds, actually. Selby has been estimated to be a 1 in 140 year event and is about as bad as you’re going to get. Most of that risk will immediately be farmed out to the reinsurers anyway, so the loss is spread around the market. And $100m is a drop in the ocean when you compare it to $50bn for WTC or $70bn (today’s money) for Hurricane Andrew.

That’s the point. For the insurance market, a large loss is absorbable. For the individual, even an “attritional” risk (less than about £50k) is likely not to be. The risk should be held by those with the capital to support it.

We should probably start a new thread if we want to discuss this further. I’d be happy to throw in as many pages of insurance theory as is interesting.

pan

54

I should clarify my second paragraph really. In case it isn’t clear, the point is that “unlimited” in practical terms for an insurer writing motor liability is a long way from the implications of “unlimited” in other areas of insurance.

And as with everything else in insurance and, for that matter, finance generally, it’s all about capital use. Follow the capital provider, the systematic risk associated with the capital project and the resultant return on capital and you can start to focus on how that capital should be used and how it can be broadened.

pan

55

No, you may have “effectively” unlimited coverage, but the total resources of your insurance company are limited.

kabbes

When it’s a few thousand dollars, I can see your point. But when it gets to be $100M, I start to question it. If someone designs a railroad crossing such that one guy screwing up can cause $100M in damages, doesn’t the person who designed it have some responsibility? If I crash into a $10,000 car, I can see why I’d be liable for $10,000. But if I crash into a car carrying $10M worth of paintings, I’d say the other guy shouldn’t have been that careless with $10M worth of paintings. And why just driving? Why not require everyone to carry “general dumbass” insurance, to pay for people who manage to cause massive damage without the help of a car? And the idea of requiring everyone to take responsibility for their actions (through the tort system), and then requiring everyone to not take responsibility (through getting insurance) seems odd to me. It’s like requiring the CEO to buy at least 5% of the outstanding stock, then requiring him to buy put options. Why not just eliminate the tort system, and pay for damages out of taxes?

56

Ryan,

You have pointed out a couple of the many salient stupidities of insurance as well as of the tort system. The “eggshell skull” theory of the tort system basically places the risk of loss on the one who “causes” the loss. Thus if you drive an old Beetle and hit a BMW, cracking the taillight lens, you are assessed damages that can amount to more than the value of your own car. And if you slightly injure a woman carrying a fetus, causing her to miscarry, you are charged with that. This is irrational, since the behavior of the two “victims,” though not negligence in the usual sense, did contribute to the magnitude of the loss. If they, on the other hand, were to hit you, the injuries would be slight because you are driving a cheap car and not carrying a fetus. This distinction is not recognized in the insurance or tort systems.

As a matter of sensible public policy, the burden of loss should be placed on the person in the best position to avoid the loss: Guys in expensive BMW’s and pregnant women should be kept off the road, perhaps. I subscribe to the theory that the best tort system is the one that assesses costs resulting from accidents in the way reflecting what the participants would have agreed to if they’d had a chance to form a contract beforehand. There is no way that a rational person would agree to participate in a football game or in driving on the road with people with such eggshell skulls. Unfortunately, I had no voice in forming the prevailing irrational rules, and for that reason, among others, I do not participate in insurance. And if I were to cause an accident resulting in the breaking of an expensive lens or the death of a fetus that shouldn’t have been there, I would feel no moral obligation to pay full restitution for the losses.

The rational rule in case of the fetus is difficult, but it is easy in the case of the tail light lens. The rule should be: if you break someone’s lens, you owe restitution equal to the cost of some average, or standard lens. This would result in the BMW owner’s recovering a fraction of the damages and, if the tables were turned, the VW owner’s recovering more than the damages suffered. This rule would carry the social benefit that folks would be encouraged to place at risk only what is needed to get a job done. That would tend to bring down losses and insurance premiums over the long term.

As it is, current insurance rules bring tremendous economic inefficiencies and moral hazards, such as: the insured person is more likely to get sued, the insured is more careless, the insured inflates damages, the insured stages accidents. Basically, insurance is anti-social. Fortunately, the religion of insurance has not spread much outside of Europe and North Amerika!

Unfortunately for me, my wonderful medicare, for which I’ve paid premiums since 1965, won’t do me any good when I retire in South America. Unfortunately for the insured Germans I knew there, their vaunted cradle-to-grave insurance didn’t do them any good when they died as a result of an automobile accident in Bariloche. Unfortunately for the average black American male, he will die the year before his social security payments kick in. What insurance does is tax away your life opportunities, unfairly discriminate on the basis of race, age, sex, and marital and family status, and give you every incentive to waste resources, cheat and defraud your neighbor and to stay home and do nothing in your own boring country.

Fortunately, except for social security and medicare, the American resident of NH, TN, WI, and even CA, is not forced to carry insurance to live or to drive legally anywhere in the country, though he still pays for the general stupidity of insurance with every tax dollar, such as those squandered by FEMA in helping Californians rebuild their wooden homes in one of the world’s fiercest fire zones!