Investors have been taught that one of the key tenets of successful investing is the idea of “dollar-cost averaging.” According to Investopedia.com, dollar-cost averaging refers to the purchase of “a fixed dollar amount of a particular investment on a regular schedule, regardless of the share price. More shares are purchased when prices are low, and fewer shares are bought when prices are high.”
Intuitively, this makes a lot of sense. If you have done your homework and have high conviction about a particular company, you should welcome the opportunity to add a greater number of shares at a lower price. Conversely, if the price is high, it makes sense that you should buy a lower number of shares.
Warren Buffet is one of the adherents of dollar-cost averaging. During market swoons, Buffet always reminds us that he is adding to his high-conviction positions. “Be greedy when others are fearful,” he says. What Buffet is trying to tell us is to take the emotion out of the investing process. Successful investors are dispassionate in their decision-making. Periodically buying a fixed dollar amount of a particular stock, regardless of price, eliminates one very influential pitfall. As we’ve said many times in these Market Commentaries, emotions are the foe of the long-term investor.
But is dollar-cost averaging always a wise strategy? Obviously you need to have conviction in the investment you are buying, and you don’t want to “throw good money after bad,” as they say on Wall Street. But are there specific cases in which dollar cost averaging doesn’t make sense?
Index ETFs, which have seen huge gains in popularity in recent years, can be an exception to the rule at crucial turning points in market cycles. Again from Investopedia.com, index ETFs are “Exchange-Traded Funds that follow a specific benchmark as closely as possible.” Take, for instance, the SPDR S&P 500 ETF (ticker symbol SPY), which is an ETF simply designed to track the performance of the S&P 500. ETFs like these have gained in popularity because of their low fees and the perception that many active managers are unable to keep up with their benchmarks. Also, many ETFs have built-in diversification, which is another one of the tenets of successful long-term investing. But when it comes to getting the full benefits of dollar-cost averaging, index ETFs may not always be the best option.
To illustrate my point, I included a chart of the S&P 500 industry weightings going back to 1993. You will see that the weightings of the various 10 industry sectors can change quite a bit over time. For instance, the weighting for the Information Technology sector was 12.3% at the end of 1997. By the end of 1999, that weighting had increased to 29.2%. And by year-end 2002 the weighting had fallen almost all the way back to just 14.3%!
If you were an investor using the SPY to dollar-cost average at the end of each year, over 29% of your 1999 contribution would have gone into a sector that was clearly, in hindsight, in bubble territory. Conversely, when Information Tech stocks got cheap again in 2002, only a little over 14% of your yearly contribution would have gone into that sector. To me, this seems like the opposite of dollar-cost averaging. The whole point of dollar-cost averaging is to buy more of an investment when it is cheap and less of an investment when it is expensive.
While the volatility in the Information Tech sector is the most pronounced example, there are several other examples over the past couple of decades. Take, for instance, the Financials sector, which went from a weighting of 13% in 1999 to over 22% in 2006, and then back down to 13% by 2008. Would you have allocated 22% of your investment dollars to the Financials sector in 2006? Or the Energy sector, which went from a weighting of under 6% in 2003 to over 13% in 2008, and back to about 6.5% today. Is the beaten-up Energy sector, which has dropped more than 42% from its highs in mid-2014, worth more than 6.5% of your investment dollars today? I would certainly think so.
The problem with using index ETFs to dollar-cost average is you are not allocating the same dollar amount to each industry sector. Instead, the current sector weightings determine how much of your annual (or quarterly or monthly) investment goes into each sector. This is a problem, particularly given the Fed’s proclivity to produce booms and busts over the past 20 years. We’ve seen bubbles in Technology, Financials and Energy shares in the past 20 years, and we’re likely to see more in the years ahead. In short, the sectors that have gone up most and are most expensive will always get the majority of your new dollars while the sectors that have fallen most will get the least. It is pretty much “buying high.”
This is just one of the reasons that tracking the sector weightings within an index like the S&P 500 can be a very informative tool for investors. While you obviously cannot predict precisely when an individual sector is topping or bottoming out, you can apply a little common sense and reduce allocations to those sectors that appear expensive (and vice versa). Active management isn’t dead, it just needs more people to stick up for it!