By David Koch, CFP®, AIF®, CFA, Senior Wealth Advisor
Part 4: Trading Strategies: Dollar Cost Averaging, Rebalancing and the Moving Daily Average
”What is a Stock?” is a 4-part piece from our Advisor Insights series Talking Shop with David Koch. If you missed it, read Part 3: Active, Passive and Factors
If you have cash to invest, Dollar Cost Averaging (DCA) is a strategy in which you deploy investable cash in slices or chunks, also called tranches, over time. It addresses what we call timing risk, which is the risk that prices will go down right after you invest. This is always a risk – but investing in tranches over time smooths out the timing risk across several entry points; you average your cost basis across each one.
Because markets tend to go up over time more often then they go down, one major consideration is that, roughly 70% of the time, you would have been better off just deploying everything at once on day one. Statistically speaking, DCA is a bad strategy: You’re going to be wrong more often than being right. Behaviorally speaking, however, no one wants to see a freshly minted investment go down.
If someone is indecisive about when to enter the market, DCA moderates the timing risk and can get investors to take action when they may not have otherwise. You’re never going to have perfect timing. In poker this kind of commitment is called limping in; in investing it’s called legging in. If spreading out the timing helps investors sleep better at night, well, there’s value in that as well. As the Chinese proverb goes, “The best time to plant a tree was 20 years ago. The second-best time is now.”
One technicality I would like to point out: DCA is different from what should be called “auto-investing,” in which you invest a little bit on a regular schedule – think about having a 401k plan at work. Every two weeks when you’re paid, a little gets invested into your 401k. People use them interchangeably, but I would argue that DCA is more about deploying cash that you plan to invest, and auto-investing is deploying new cash as it comes in.
Most often, portfolios are constructed with either an expected return or an expected level of risk – or some combination of the two, i.e., a risk-adjusted return. Once a portfolio is constructed, each asset class and/or underlying security will have what’s called a “target allocation” to best achieve these objectives. Well-constructed portfolios will have thresholds on either side of each target (above and below). When these thresholds are crossed, this will alert the portfolio manager that some trading is in order. This is rebalancing: You’re bringing the portfolio investments back to their target levels.
For example, if we started with a 60% stock/ 40% bond portfolio in January 2010, without rebalancing, this would have grown into a 90% stock/ 10% bond portfolio by January 2020. If an investor thought that she was taking on the risk of a portfolio made up of 60% stocks, but she never rebalanced, she would have been in for a big surprise the first quarter of 2020 to find that she owned a portfolio with a 90% allocation to stocks.
Rebalancing is typically a risk mitigation technique. Let me explain. Under normal conditions, and over longer periods of time your riskiest assets in the portfolio (like stocks) would be expected to grow more than the less-risky assets (like bonds). Therefore, you would end up with more risky assets in the portfolio than what you began with because they rose in value more than the others. Because of this, the process of rebalancing usually involves selling the riskier assets and buying more of the less-risky assets.
In times of market corrections or crashes, however, the reverse is true. When risky assets sell-off and they break the lower boundary, it will trigger a rebalance in which you’ll be selling less-risky assets and buying riskier assets. So, while under most circumstances rebalancing is a risk mitigation technique, under these circumstances it can become a return enhancer. By buying more stocks in times of stress, the rebalancing process forces investors to systematically buy more stocks at depressed prices – and they rebound more quickly when the market recovers.
Adding up the closing price of a security over a period of time and averaging those prices creates a Moving Daily Average (MDA). It is moving because each new day adds a new number that goes into the average, just as the oldest one falls off. The time period that’s being averaged could be as short as a few days, sometimes 20 or 50 days, or for longer periods like 100 or 200 days.
The purpose of calculating a moving daily average is to determine a price trend. This is also known as momentum. If the current price is above its average, then it is trending up and is said to have positive momentum. If the price is below its average then it has negative momentum. The longer the time period in the MDA, the “stronger” the trend signal is considered to be. If the price is above its 10-day average, that’s not nearly as strong as being above a 100-day average.
Trend following is a strategy that is used by many traders, and across many markets. Trend-following strategies aren’t just applied to stocks, but are used for many things, even commodities like gold, oil, corn and wheat – nearly everything traded will have someone running a trend-following strategy around it. The moving daily average provides a systematic methodology to determine a trend in the markets. The signal is often used as a binary trade – you’re either in or you’re out. If the price drops below the MDA, you sell. When the price improves above the MDA you get back in.
Shorter signals are more influenced by noise than longer signals and thus following a shorter trend signal typically requires more frequent trading. An investor may get out closer to the top and get back in closer to the bottom – but he may end up trading fruitlessly without any real trends materializing.
Cocktail tidbit: One common trading strategy is to follow when the 50-day and 200-day moving averages cross each other. Traders who follow this strategy will exit a security when the 50-day moving average crosses below the 200-day average; they call this the “death cross.” On the other way around, when the 50-day moving average crosses the 200-day average on the upside, this is considered a bullish signal. It’s called the “golden cross.” Traders use zany names for much of what they do.
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The views contained herein are not to be taken as an advice or recommendation to buy or sell any investment. Any forecasts, figures, opinions or investment techniques and strategies set out are for information purposes only, based on certain assumptions and current market conditions and are subject to change without previous notice. This material should not be relied upon by you in evaluating the merits of investing in any securities or products mentioned herein. In addition, the Investor should make an independent assessment of the legal, regulatory, tax, credit, and accounting and determine, together with their own professional advisers if any of the investments mentioned herein are suitable to their personal goals. Investors should ensure that they obtain all available relevant information before making any investment.