Dollar Cost Averaging versus Stop Losses

Subscriber Rick G. recently asked a great question.

“What do you think about the theory of ‘buying on dips’ and ‘dollar cost averaging’?

If the price of a dividend paying stock goes down, buying more will increase your yield; however, that seems to be at odds with the idea of why an investor should have stop losses. How does this affect retirement investors?”

Dollar cost averaging is a simple premise. If you spent $1,000 for 100 shares of XYZ stock, your cost per share is $10. If the market price drops to $5/share, and you buy another 100 shares ($500), you would now own 200 shares. With $1,500 invested, your average cost per share is $7.50.

Let’s get right to the heart of the issue. The initial $1,000 investment would be worth 50% less than what you paid for it. Buying more at the current price (“dollar cost averaging”) does not change the fact the original shares are now worth less.

The investor is hoping the stock price has bottomed; the price will rise, and turn a loss into a profit. Should ABC rise 50% the investor would be at break even. If it doubled and came back to the $10 price you would show a profit.

When the market collapsed at the end of the Internet boom, I saw EMC drop from approximately $104/share all the way down to $4/share.

Some dividend investors believe they are buying dividend income and should not be concerned about the share price of the stock – as long as the dividend is safe. They say things like, “You only take a loss when you sell.” The idea of “buying on dips” is something they embrace.

If XYZ is paying an annual dividend of $.25/share, the investor would earn 2.5% dividend yield on the shares they bought at $10/share and 5% on the shares they bought @ $5.00.

The theory has some merit, as long as the dividend is safe and the investor can stomach paper losses, which can, and will, occur.

Stop-loss orders are designed to protect against catastrophic losses. Retirees, in particular, are heavily focused on preservation of capital, and many cannot afford to see the value of their nest egg drop radically.

The Perspective of Time

I recently interviewed Jeff Clark about his article, “This Chart Might Make You Rethink the Adage Stocks Always Come Back.” We discussed the idea of “coming back in our lifetime.” He summed it up well:

“It’s basically an issue of time. I have a daughter just starting out in her career, and a son getting ready to do the same. They have 40 years to invest, capitalize on compound interest, and important to our discussion, recover from a major stock market crash….

My wife and I are in the middle of the picture. We have a decade before we retire, so we can take advantage of normal corrections and dips. A crash is a different story. I am forced to consider what might happen to the stock market over the next decade, which is what prompted me to research this topic in the first place. If it takes 20 years to get back to even, including inflation, that would definitely hurt us if we were in the stock market.

On the other end of the picture is my retired parents, both of whom are approaching 80 years old and clearly don’t have a large time frame to wait for stocks to come back. A crash to them would be devastating. They’re forced to avoid that risk.”

Each stock and each investor is different. Setting a stop-loss alert on speculative or thinly traded stocks is still prudent to keep on top of things before they get out of hand. In some cases, buying on dips may make perfect sense as long as you do not overload your portfolio on one issue.

Regardless of your age, consider learning about and applying stop losses or alerts. Young people may set stop losses at different levels (for example, 25% instead of 10% or 15%), but having any alert in place still makes sense.

Almost every investor I know has a story about riding a stock down, “holding on a little longer hoping it will come back” – and finally capitulating, wishing they had sold earlier. Why does this seem to be a universal lesson every investor must learn the hard way?

The Retirement Investment Challenge

Rick G. asked, “How does this affect retirement investors?” We need to listen to the expert’s advice and understand the source, which includes their credentials and experience.

It’s easy for young financial planners to tout “dollar cost averaging” and/or “the market always comes back.” It is unfair for baby boomers and retirees to think young people can truly understand our fears. I recently wrote about how things change when you retire:

“It’s a scary feeling when you retire and cut the cord from your full-time job.

Once retired, things changed overnight. In the past when I took a loss, I had my job and the benefit of time as my security blanket. With that security blanket removed, risk tolerance, confidence, and the emotional reaction to taking losses all changed.

Several friends had recently rolled their 401k into self-directed accounts, and we discussed our feelings. My friend Pete said it best, “If you are not a little bit scared, you don’t understand the problem!”

Why is preservation of capital so important to retirees? In my article, “Stop Losses Are a MUST For Retirement Investors”, I outlined the harsh reality many retirees face today. They can no longer “live off the interest” and have to dip into their nest egg each month to help pay the bills.

Before the Fed bailed out the banks, many had enough income to live, plus some left over to invest and continue to grow their portfolio. Unfortunately, particularly for many in the middle class, their retirement income is a fraction of what they targeted when they were funding their retirement.

There are times “buying on the dips” and “dollar cost averaging” can be used to the advantage of all. I’m a strong believer in diversification, recommending that no single stock should be more than 5% of a senior’s portfolio, with a stop loss (or alert) set at 20%. If you got stopped out, the worst possible case would be a loss of 1% of your overall portfolio.

An investor does not have to buy 5% right away. Particularly with dividend stocks, many prefer to buy a smaller amount and automatically reinvest the dividends to buy more shares. In addition, you may consider using a trailing stop to lock in investment gains as the stock rises. Over time this will come closer to true cost averaging.

One issue seldom discussed among dividend investors is the idea of rebalancing. One investor friend, touting significant gains said almost 50% of the portfolio was invested in Apple stock. At what point do you lock in some gains, sell off part of your winner, and rebalance your portfolio to reduce the probability of catastrophic losses?

I’ve asked many financial planners about these issues and the most common response is, “It depends on the client’s risk tolerance.”

WHOA! Hang on a minute!

Investopedia defines risk tolerance this way:

“Risk tolerance is the degree of variability in investment returns that an investor is willing to withstand. … You should have a realistic understanding of your ability and willingness to stomach large swings in the value of your investments; if you take on too much risk, you might panic and sell at the wrong time.”

I have many retired friends who have the risk tolerance of a riverboat gambler.

Whether you are self-managing your nest egg or working with a financial planner, you must “run the numbers” and use some common sense.

Each investor is different. If a retiree has to dip into the principal each month to help pay the bills, the idea of buying on dips or dollar cost averaging is irrelevant because they are not generating additional investment capital.

With the exception of ultra-wealthy friends, or those with juicy pensions, a very common remark is, “I’m no longer trying to get rich, I’m just trying to keep from getting poor.”

“Buying on dips” and “dollar cost averaging” is not necessarily bad advice. Nor is it bad advice when I tout stop losses and preservation of capital being the goal. Investors should read advice from many different points of view and decide what best suits their situation.

Each editor writes about what they believe; however, there is no “one size fits all” solution. Your job as a reader is to weigh the issues and determine what fits best for you and your life situation.

Until next time…

This article was originally published on Dennis Miller’s free website Miller On The Money. Join today and receive his articles – Straight to your inbox for FREE! PLUS, when you join, you will receive Dennis’ Special Report – An Honest Persons Guide to Social Security – Absolutely FREE!