Feb 06 Dollar Cost Averaging: Avoiding the Oldest Trick
Like my article on Day Trading Discipline, I strenuously warned against the temptation of holding overnight positions. There are thousands of rookie mistakes that day traders make that they shouldn't be making in the first place, it's called day trading for a reason, it's not called night trading. No overnights would be rule #1, don't hold your stock past the closing, you are in this stock market to get in and get out, that's why you are trading early. A VERY close second is no dollar cost averaging but I'll get more into that with my free beginner class for day traders, I'll answer your day trading questions there.
What Is Dollar Cost Averaging
For those who don't know what dollar cost averaging is, I'll explain, the definition of dollar cost averaging is the process of buying additional stock after you've taken a prior loss. The rationale for doing so is that now that the price has been "discounted" you can buy more of it and therefore increase your chances of making a profit.
Here is an example. If you've ever dealt with a stockbroker then you have very likely been introduced to this strategy. Dollar-cost averaging is infused in every stockbroker's fictional handbook under the chapter "They'll fall for it every time". Here we go:
Dollar Cost Averaging: "They'll Fall For It Every Time"
Your broker calls and pitches XYZ stock. According to your broker, this company has the greatest product, management, and marketing strategies. It's going to revolutionize its industry. The broker is so excited about the stock that he has not only put all of his money into it but he has put his grandmother's retirement fund into the stock too. You figure that he wouldn't steer his grandmother wrong, so you buy 1,000 shares at $30 per share. Over the next few weeks, the stock price falls to $15 per share. You've lost $15,000 or half of your original investment, you think to yourself, "My broker's poor granny, her retirement fund was wiped out!". Well, perhaps that isn't your first thought but you are distraught nonetheless. Lost money is never good, you want to make money in day trading.
You are awoken from the trance by the telephone. It's your broker on Line 2. You can't believe it! After such terrible advice, you didn't think you'd ever hear from him again. You're even more shocked when he calls to tell you the "good news" - that XYZ stock has lost half its value.
"That's good news?" you practically scream into the telephone. "No. Its great news!" He responds practically reading word for word from the fictional handbook. "If you thought XYZ stock was a good investment at $30 per share, it's a 'steal' at $15 per share. For the same $30,000 you can now buy 2,000 more shares of stock. In that case, if it just goes back up to $20 you'll break even. If it goes back up to $30, you'll be up by $30,000. And if it goes up to $50 (and the broker is sure that it will), you will make ... get this ... $90,000! You just have to buy more shares! It's a no brainer!"
The Risk of Dollar Cost Averaging
Now, here's the strange part. You probably will buy more shares. Why? Because like most people, you can't stand the thought of cashing out on a losing investment. After all, the point of buying stock is to buy low and sell high. However, by dollar-cost averaging down the price of your investment, you increase the chances that you'll eventually break even, if not make a profit. So why not, right?
Wrong! The poor house is full of people who dollar-cost averaged away fortunes. They kept buying stocks like Enron, Nortel, JC Penny, and DELL Computer. In many cases, they did so at the advice of a stockbroker. That stockbroker earned a commission on each trade that was made! Not a great deal right?
As a day trader, you won't have an outside stockbroker trying to talk you into dollar-cost averaging. You will have an "internal stockbroker" trying to talk you into doing so to avoid cashing out a losing position. For example, let's suppose you buy 1,000 shares of stock at $19.00 and it falls to $18.10. You're down $900. Your internal stockbroker might try to talk you into buying another $1,000 shares with the thought that you can wipe out your loss if the stock just inches up another $0.45 to $18.55
Hang up the phone! The stock may very well inch back up, but it isn't worth the risk. Think about it: you're putting an additional $18,000 on the line to avoid a $900 loss. You could lose as much as $37,000 (Remember, you invested $19,000 on the first trade). Just because you're unwilling to accept the loss of $900.
You're sure the stock is going to rise right? Are you 100% sure? You didn't have a good grasp on the direction of the stock when you brought it the first time. Why do you think it will be any different this time? Wouldn't it be better to just consider it a lesson learned and be done with it? You don't need to make the same mistake twice, that's why you learn once and apply your leanings to your strategy.
"$900 is a very inexpensive lesson. Why make your loss almost 400 times greater to learn the same lesson?"
Think about this for a moment, you don't have to make the same mistake. When you are wrong about a stock and you will be, don't turn a small loss into a big one. Simply cash out the position, take your loss and move on.