DCA! DCA!

I recently read a post by a so called FIRE investing hot shot. I’m growing increasingly disillusioned with FIRE narratives. In the post a reader asked a question about how to invest something like $100K sitting in the bank in cash. The blogger went into this long explanation about dollar cost averaging over 3 to 6 months, bla, bla, bla! Lets think about that advice in the face of what we actually own when we own a retirement portfolio. The misunderstanding comes from the mistaken belief stock portfolios compound interest. THEY DO NOT! Bond portfolios can be setup to compound interest and there is a class of bonds called zero coupon bonds that automatically do this. You buy a zero coup at a discount and some number of years later the bond pays you what you would have had, had you reinvested the coupon yearly for that number of years. Interest compounding means you take a principle and multiply it by the interest (the coupon) and add that back to the principle so the next year both the principal AND interest get a new dab of interest. This is the actual “magic of compounding”. In fact the magic of compounding is what lead Leonhard Euler to discover the number e. e is an irrational number and is the base of the natural logarithmic system like 10 is the base of the base 10 logarithmic system. If you’ve seen a log equation using the notation ln() instead of log(), ln refers to the log base e. It turns out if you have compounding going on you can divide the interest payment into periods, once a year, twice a year, quarterly etc, and it turns out because of the interest being added back to the principal the more often you add interest the better the investment. Euler studied what happens to the magic if the interest is taken to the limit of continuous compounding. That limit turns out to be a number called e and is about 2.718. You might call e MAX MAGIC! Note in tax law interest is taxed as ordinary income which tends to define it’s asset class. Interest is not converted to cash IT IS CASH. Compounding therefore is not a variable, it is a constant and best compounding is defined by the number e. The money you make compounding is strictly defined by the length of time, the interest rate and the period of payment back into the principal. Interest is covered by 4th grade math. There is a bond market where you can buy and sell bonds but it’s the 4th grade math that sets the value of one bond compared to another, so the bond market is secondary. If you hold a bond to maturity it will pay you exactly what the contract specifies (assuming the bonding agency is still solvent) This is why bonds tend to be lower risk because you own a contract to pay you cash, and your risk is related to failure not variability. Good bonds low risk of failure, bad bonds high risk. Good bonds tend to pay low interest because the risk is small, junk must pay high interest because the risk is high. In addition you get paid a premium for how long your willing to tie up the money. There is more but these features are what is salient.

Stocks on the other hand are not cash, not cash at all. Stocks are property, and a stock’s return is entirely variable and set by a market action. Let’s buy some IBM! We see IBM is $100/share and we decide to buy 1000 shares and pony up $100K. We now own some property! The very next day IBM pays a dividend, enough to purchase another 100 shares because we checked the box “reinvest dividends” so we now own 1100 shares of IBM and on this day after the dust settles IBM goes up to $105 and our 100K investment is worth 115,500 wow! Notice we had something like compounding occur in that the company paid out some money and reinvested that for us by buying more property but the company determined what was paid out, if and when. There was no contractual payout like with a bond. The payout is a variable. In addition the value of our property was set by the market response to the divided. People decided IBM property this week was worth 5 bux more compared to last week, so that entire improvement in value was due to variables and not constant as defined by a contract. This makes owning IBM risky, volatile and variable. The next month IBM gets a 10B lawsuit and the stock drops to $90 You still own 1100 shares but the value is now 99K and you’re under water! HOW CAN THIS SEQUENCE REPRESENT COMPOUNDING? In fact it does not represent compounding. Instead of a linear predictable return, the “return” is all over the map or shall we say all over the risk reward plane. IBM is 2 dimensional, it has a risk and a reward and the risk and reward are set by market speculation and business activity.

This is the key understanding that is missing in the FIRE narrative. What you do when you buy a stock is place some money at risk and hope to God for some return. Underlying that return is the economy, the company and things like rule of law, and a stable currency, and a stable capitalistic society and you make a judgement the reward will be worth the risk. This is why people freeze when investing and why someone ends up with 100K in cash in a bank account. Notice in the above example you were 15K ahead an 1K down in a week, The next month the lawsuit is dismissed and IBM over the next 4 months rises to a steady 136, same 1100 shares of property your 100K is now 150K. Wait a minute your hamburger account is empty and you need some beef! So you sell 10 shares for $1360 and you buy half a steer and freeze it! You now own 1090 shares of IBM up 90 shares from the original 1000 shares, you got a meat locker full of hamburgers, break out the charcoal! 1090 shares are worth 148,240

Note what paid you here. It was not compounding or cash, it was risk. In an equity portfolio you d on’t make the return until you take the risk. In 6 months in this example you were up 50K! Suppose you dollar cost averaged at 20K per month You’d buy 20K of IBM month 1 for 200 shares and get an additional 20 shares from the dividend you own 220 shares and have 22K in stock value and 80K in cash. The next month the stock is 90 and your 20K buys 222 shares so you have 442 shares and the value is 39,780 plus you have 60K in the bank IBM is stable at 136 for the next 3 months of purchase and you buy an additional 441 shares over those 3 months for a total of 883 shares. Month 6 the meat locker is empty and you need to buy some burgers for $1360 bux that’s 10 shares. So at the end of 6 months you have a full meat locker and 873 shares worth 118,728

Wait a minute isn’t dollar cost averaging supposed to pay you??? The FIRE hotshot told me so!!! You only get paid for taking risk. Taking risk is known as buying IBM. If your dough is sitting around in the bank it’s not at risk so you ain’t getting paid! You spent 6 months playing with yourself, pretending to be “smart” because some swinging weenie told you so! When is dollar cost averaging smart? When you invest every month! The whole point is to get the dough at risk ASAP and not sit around accumulating money in the bank. Once you decide on your risk like a 60/40 market risk of 62% just put the damn money in the market at 60/40 ASAP. If you don’t understand these relationships COLD you don’t understand jack. If you’re wasting your time worrying about saving 2bp on your portfolio cost YOU DON’T UNDERSTAND JACK. Sure the sequence could have been written to give the dollar cost average a better outcome but that misses the point that it’s the risk that pays you. Over decades in a rising economy the little piddling around with dollar cost averaging a wad is a waste of time. In a falling economy like Japan post 1990 you’re hosed whether you dollar cost average or not because one of those variables is “the economy” and if the economy is busted DCA doesn’t matter a whit.

If you understand this post you understand 90% of sequence of return risk. Bonds are not correlated with stocks which means even if they don’t make much money, they don’t loose money so they are a ready way to shuttle money into and out of stocks. That’s what the AA sets, the risk and the 2 funds allows for cycling between buy low and sell high. Stocks high? sell a little and stash in bonds do that for a few years since in our economy stocks are down <20% of the time. When stocks crash you re-balance some of that sold high stock money you stored in bonds back into stocks when they are cheap. If you have extra money you add according to the AA and you would buy relatively more bonds when stocks are high with the extra money to also be used to buy stocks when they go low. That’s the juice dollar cost averaging buys you. Recall interest was taxed as ordinary income stocks are taxed as property using capital gains two very different tax treatments for two very different investment classes. If you’re analyzing your stock portfolio by using what is effectively a bond interest calculator you ain’t playing with a full deck. The other thing this post shows is the danger of thinking living off dividends is “safe” Dividends I think provide some diversity but only if reinvested, which then puts that money back at risk by buying more property. Siphoning off the dividend is like siphoning off the risk in an unpredictable way. You want some hamburgers sell some of the portfolio according to the AA if the market is down you will sell more bonds than stocks if up more stocks than bonds. You are always buying low and selling high anyway. This is where my last post really comes into play. If you have a separate small low risk portfolio when stocks go low you can sell from the other portfolio.

2 Replies to “DCA! DCA!”

  1. DCA is a soporific more than an investing strategy. It lets folks who disproportionately fear a dip after investing a lump sum sleep at night with the false reassurance they need.

    If you can’t handle a drop after investing a lump sum, you don’t need to DCA. You need an asset allocation set to a risk you can actually tolerate.

    1. DCA has it’s place, which is a mechanical rule to get money at risk ASAP so it can begin growth. That’s it’s place. DCA is like PhD (piled higher and deeper). PhD is the result of the mistaken belief more equities = more diversity. Diversity is asymptotic so in and asymptotic system more = same, not more = better. If you think about buying stocks as buying risk because you want to own risk, NOT BUYING becomes your risk because not buying keeps you under risked. DCA is the Quaalude (a chemical soporific) of investing when used incorrectly.

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