chess pieces and pennies for buy lowThere is a popular way to invest called dollar-cost-averaging (DCA).  It is a simple concept that relies on the assumption that an investment will go up in value over time regardless of its highs and lows.  In other words, you put money into this investment at certain times (say every month) no matter what the price.  So when it is low, you are getting a deal, but when the price is high, not so much.  In fact, this is what you are probably doing in your 401K at work.  Now for most investors, this is a good way to go because you don’t have to think much.  It works, but don’t expect the big bucks to roll in with this strategy either.  Particularly if a stock is going up over time, you are simply paying more and more for fewer and fewer shares instead of buying low and selling high.

A Better Strategy

How about getting a discount, instead?  This is what I refer to as cutting your losses.  In short, it simply means that if you decide a price is good, you buy, and if the price goes lower, you buy more.  After all, didn’t you buy the first time because you determined it was a good price?  So isn’t a lower price even better?  Of course it is!

Now if your pick goes up right away, then it is time to watch until it reaches a point at which you are ready to sell.  In the meantime you put other money into other “low” stocks.  Some of your picks will go up right away, but my experience has been that most go down before they go back up.  This is probably due to the fact that you are buying “low,” and buying at the “lowest” rarely actually happens.  But over time, if you have picks that are down, you buy more.  When the price goes back up and you sell, you make even more than your original projection!

Dollar Cost Averaging vs. Cutting Your Losses

So let’s put some numbers to this and compare dollar cost averaging and our strategy using an ideal model to see the difference.  I am making it easy to get the point across and then we’ll move on to some real-life examples.  So let’s start off dollar-cost-averaging in our ideal stock, putting $1000 in every six months for the next five years.  This is what the chart looks like (the letters indicate where we bought at each point) and notice that the stock doesn’t even go up on average over time:sine curve stock price used to illustrate cutting your losses vs dollar cost averaging

So here’s a table of what happened:

$ Invested Price/share # of shares
A $1,000 $35 28.57
B $1,000 $50 20.00
C $1,000 $35 28.57
D $1,000 $15 66.67
E $1,000 $35 28.57
F $1,000 $50 20.00
G $1,000 $35 28.57
H $1,000 $15 66.67
I $1,000 $35 28.57
J $1,000 $50 20.00
$10,000 $35.50 (average) 336.19

                Current value (at J)=        $16,810

So basically we turned $10,000 into $16,810 even though the stock didn’t follow an uptrend.  Consequently, this is a return of about 13% per year.  That’s not bad at all, especially since you don’t have to use much brainpower.  So DCA is a decent way to go.  Although why couldn’t we have just bought at low prices and spent the rest on another “low” opportunity?  Of course the answer is that we can, although it is easier said than done.

A Different Approach

Now this time, we will assume that we bought at the highest point, and only bought more when it went below that.  Keep in mind that this would be an extremely bad decision in the first place.  So remember, we are initially buying at a high point, which we wouldn’t normally do.  But just to show you how much more you could make this way, I will be less than ideal.

chart 2 of sine curve stock using loss cutting rather than dollar cost averaging

You may notice that even though I can see the future, so to speak, I still did not buy at the lowest lows.  As a matter of fact, you won’t know exactly where those will be, but you don’t have to.  What I did do though is buy when the price was at what I would have actually determined was a low point.    So here’s what happened:

$ Invested Price/share # of shares
A $1,000 $50 20.00
B $1,000 $42 23.81
C $1,000 $35 28.57
D $1,000 $27 37.04
E $1,000 $23 43.48
F $1,000 $32 31.25
G $1,000 $22 45.45
H $1,000 $18 55.56
I $1,000 $20 50.00
J $1,000 $25 40.00
$10,000 $29.40(average) 375.16

                                                                                                                                                  Current value (at J)=        $18,758

In this case we made about 17% per year by applying just a little bit of thought into the equation, and remember, we started off with the first investment at the highest point, which I never really would have done.  It may not seem like a lot, but it amounts to about 25% MORE money over 5 years.

Although, This is What I Probably Would Actually HaveDone

Now if I had seen the first year’s changes, here’s what I would have more realistically done and models what I have actually done many times with real stocks:chart 3 of sine curve stock buying and selling at more realistic prices using loss cutting strategy

Consequently, I would have seen this stock at the end of the first year and recognized a low (at A).  But then it would have dropped even more, so I would buy more at B and C.  Then when it recovered enough, I would sell at about D.  Now before you accuse me of taking advantage of selling at almost the highEST point because I know what is going to happen, there is a simple way to ensure that you sell at a very high point if a stock keeps going up called a trailing stop-loss (more later).  So here’s what we have:

$ invested price/share # of shares
A $1,000 $35 28.57
B $1,000 $25 40
C $1,000 $30 33.33
D $48
$3,000 $30.00(average) 101.9

                                                                                                                                             Current value (at J)=          $4,891.20

This time things were a little different because I didn’t even invest all $10K.  In fact, I only even bought 3 different times.  Why?  Because after my investment at “C,” I would have realized the stock was going back up and wasn’t so low anymore and I could use the other $7K for another investment while this one climbed back up.  So although I didn’t invest all of it, I made over 60% profit in just over a year!  In the first scenario it took five years to earn about 68% on my money (assuming I sold everything at J).  However, in the second, I made about 88% (if I sold at J).  Finally, in the last scenario I made 60%, but IT ONLY TOOK 1 YEAR.

So I Can Profit From Made Up Numbers…So What?

Indeed, anyone can doctor the numbers to work out their way, you say.  Hindsight is always 20-20, but what about doing this for real, in the real world?  Actually, people with more money than you and I made billions because of the financial crisis of 2008.  Rich people started buying because BUYING LOW AND SELLING HIGH IS HOW THEY GOT AND STAY RICH.  Of course the rest of us are content to get out of these “high risk” investments that “just lose money” or just keeping plugging away at the dollar cost averaging strategy.  Nevertheless, in most cases, pouring money into those “bad” investments would have not only avoided a loss, but created a massive GAIN.  On the other hand, cutting your losses would have resulted in huge gains.  If only you had the patience to wait a few years!

If you look at the stock market from the beginning of 2009 until 2018, you will see that it has gone up.  Consequently, the same is true of many stocks in general.  So many folks sold their stocks and put their money into “safe” investments.  As a result of this an overall economic slowdown, stock prices plumetted.  As expected, they later came back as more and more people saw the value in the aftermath.

Cutting Your Losses Isn’t Just a Theoretical Trick

Many people lost, big time, by selling their stocks when the going got tough.  As a result, they missed out.  Consequently, if they would have simply kept investing in lower and lower prices, they would have made a fortune.  In fact, this is precisely what Warren Buffet has done over the decades to become a billionaire.  However, this doesn’t mean that you have to wait for a financial crisis to make money.  You can find opportunities in all markets, but in a recession the deals are everywhere.

But let’s get back to real life.  Surely it isn’t 2009 anymore and you aren’t Warren Buffet.  So is this just smoke and mirrors or does it really work?  Sometimes it has taken years of patience but it has worked for me every time alongside the other principles discussed on this site.  I have a truckload of examples, but let me give you one of my favorites from early on that convinced me I was on the right track.

Goodyear Tire (GT)

The company is Goodyear Tire (GT), a business you may have heard of once or twice.  Because I saw an opportunity in 2002, I jumped in.  The “problem” was that it would still drop into about ¼ of its value.  At this point, most folks would assume they made a mistake and sell at a huge loss.  But I just kept seeing better opportunities.  Here’s a chart of what happened and when I bought:

goodyear tire chart of my buys and sells

I bought at points 1, 2 and 3 and sold at point 4.

Date Action $ invested price/share
1) 05/9/02 buy $1,000 $22.19
2) 5/22/03 buy $1,000 $6.64
3) 12/01/03 buy $1,000 $6.80
4) 11/24/06 sell $17.74
$3,000

Value at selling =

$6,080

I basically doubled my money in a little over four years by buying at a “low,” and buying more when the price had dropped.  At the time the so-called experts would have advised me to sell to preserve what little I had left.  However, I stuck to my guns and I sold at a LOWER price than when I first bought it and still made an average of 25% per year.

My Way vs. Dollar Cost Averaging

Now let’s compare this to dollar cost averaging.  We will assume that I still bought at the same initial time and sold at the same time, but that the two buys in between were at equally spaced intervals as dollar cost averaging would prescribe:

goodyear tire chart 2 of theoretical dollar cost averaging scenario

Date Action $ invested price/share # of shares
05/01/02 buy $1,000 $22.19 45.07
11/02/03 buy $1,000 $8.00 125.00
05/05/05 buy $1,000 $10.50 95.24
11/24/06 sell $17.74
$3,000 265.30

Value at selling=         $4,706

Notice that dollar cost averaging still brought in a return, but not nearly what cutting my losses did!  The real advantage to cutting your losses  is that you only invest more when the price has gone downWith dollar cost averaging, you invest even if it has gone up.  You are also betting that the stock will go up forever (at least on average).  But with the buy-low-sell-high strategy and cutting your losses, you only assume that the stock will do about the same thing that it has in the past!

In Conclusion…

I won’t bore you with tons of other examples, but I do have many.  In fact, I have used this precise strategy of cutting my losses many times.  For example, I have done this with Bank of America, AIG, Facebook, Nordstrom, Martha Stewart Omnimedia, Big Lots, Walmart (twice), Rawlings Sports, Target (3 different times) and many others.  While it may be true the I know what I’m doing, I’m not “in the know.”  In addition, I don’t have any billionaire friends telling me what to do.  Nevertheless, I do this with everyday stocks of businesses you use all the time and you can do it too!