Investopedia defines dollar cost averaging as: The technique of buying 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.
Why It Works for Stocks
This is a great idea. This concept alone has allowed average Americans to become participants in the American dream of accumulated wealth. By investing a little at a time consistently and constantly, trillions of dollars have become concentrated in the 401(k)s and individual retirement accounts (IRAs) of an entire generation of Baby Boomers.
When prices are strong, there are benefits to dollar cost averaging. The old saying “The trend is your friend” definitely applies. You are constantly buying a stock that is getting stronger and stronger, with the added benefit of your overall portfolio lifting up in value. When prices are weak, or more importantly stagnant, but the company is still sound, you are able to buy shares at a flat or less expensive rate.
This is perfect for stocks. The market moves in only three directions: up, down, or sideways; most of the time, markets are moving sideways. Couple this with a buy-and-hold philosophy, and you can accumulate shares with little regard to where the price is. You own the shares, and there is no time limit on when they have to perform well.
While this may be a great idea on the surface, dollar cost averaging is difficult to apply to futures and forex trading. In futures and forex trading, a similar activity is “pyramiding” your profits. You add on more leverage based on the profits from contracts that are successful. When it comes to “adding” more contracts to a leveraged position, you have to worry about how much capital you have, margin calls, and the fact that longs and shorts are treated equally.
Since the markets are leveraged, you have to keep in mind that by adding one more contract, you are doubling your losses and gains. If the volatility of the underlying market is at 2% to 3%, with leverage of 20 to 1, you are gaining and losing at 40% to 60% of your capital outlay on one contract. On two contracts, you are at 80% to 120%, and at three contracts, you are at 120% to 180%. This is why you can give back accumulated profits in no time. What took you X number of days to accumulate is given back 2X to 3X faster.
The same occurs if you are attempting to protect yourself against loss. If you are adding more contracts as the market moves against you, you must make sure that you have enough capital to cover the maintenance margin of the contracts you have, plus you must be able to put on the initial margin for each contract you add. With futures contracts having initial an margin of $2,000 to $5,000 and forex account contracts around $1,000, a small account of $10,000 would possibly have three to four chances at dollar cost averaging futures or forex contracts before the account runs out of steam in maintaining current contracts and adding on new contracts. All the while, you are losing cash at an accelerated rate.
This bumps up against the third problem. Stocks have an inherent bias-everything goes up. So even when the prices pull back, there are few that are actually actively driving the price downward; there is just an absence of buying activity at current levels. So the price moves down until a buyer is found at a level that is comfortable.
In futures and forex there are active participants who want to see the price drop or expect the price to drop. Either way, there is no one-sided bias, and this has tremendous impact on how low a market can go. If you are attempting to dollar cost average a significant drop in price, it’s akin to catching a falling knife. The reality is that futures and forex are better traded with the trend, as opposed to attempting to build up a position while the market is strongly moving against you.
Investopedia defines value investing as:
The strategy of selecting stocks that trade for less than their intrinsic value. Value investors actively seek stocks of companies that they believe the market has undervalued. They believe the market overreacts to good and bad news, causing stock price movements that do not correspond with the company’s long-term fundamentals. The result is an opportunity for value investors to profit by buying when the price is deflated. Typically, value investors select stocks with lower-than-average price-to-book or price-to-earnings ratios and/or high dividend yields.
Why It Works for Stocks
What is the “intrinsic value” of a stock? Who determines it? What if you get it wrong?
The big problem to value investing is the “how” of estimating the intrinsic value. Determining the correct intrinsic value is difficult. Any number of investors are capable of looking at the facts and still coming to different conclusions, just like that round robin game. A lot of thought has to go into the potential price discrepancy. It definitely takes a lot of speculative prowess.
Whether you look at present assets/earnings or place value on future growth or cash flows, you are attempting to buy something for less than its worth. This can be a flawed investing methodology solely because you are buying into weakness. While our natural instinct is to constantly look for bargains, it may not be the best strategy when making investment decisions. However, value investors like Warren Buffett have turned this art into a science.
For the average stock investor, the benefit is that they have time on their side and can watch and wait to see if they made a good or bad decision. In futures and forex, time is of the essence.
Why It Doesn’t Work in Futures and Forex
When buying clothes or food at a discount, there is a gratifying feeling of getting a bargain. That same feeling simply doesn’t translate well when you are investing in fast-paced markets like futures and forex. I consider value investing on par with tarot reading or, worse, gambling.
When it comes to stocks, there is a natural upside bias. If a company’s stock is priced low and there are clear indicators that no financial shenanigans are going on in the background, it’s likely that it may eventually rebound. This same type of assumption cannot be made of currencies or commodities.
If a country is fixated on seeing the value of its currency go down, they will make it happen. For over a decade Japan’s central bank has played a key part in forcing the yen down by consistently flooding the market with yen, just so they can maintain exports. On the other end of the spectrum, cotton prices can get as low as they need to because the government subsidizes cotton farmers so that they can compete on the world stage.
What is the true “intrinsic value” of the Japanese yen or cotton? Is there an upward bias? The answer to question one is “Who knows?” The answer to the second question is “No”! How do you deal with these kind of markets-at what point do you invest in hopes that there will be a turnaround? This requires the ability to accurately pick tops and bottoms in the markets; if you can do it, I commend you.
For the most part, the whole reason why spot and futures trading exist in the first place is to discover the intrinsic value by the time of the contract’s expiration. Any attempt at determining the intrinsic value by attempting to buy cheap has the potential to be disastrous because of the leverage that these markets employ. Couple that with the fact that there is constant pressure on both the up- and downsides, and we have a recipe for disaster.
Noble DraKoln is founder of Speculator Academy, http://www.speculatoracademy.com. After becoming a licensed broker at the age of nineteen, he has gone on to author seven trading books. He is a former editor of Futures Magazine, regular contributor to Forbes, has been a featured guest on numerous financial channels, and is a sought after consultant speaker in the futures, forex, and options world. Needless to say his twenty-one years in the industry have been well spent.
He is also the author of the books Trade Like a Pro, Winning the Trading Game, published by Wiley and Sons, and the author of four book “Small Speculators Series”.
His books have been translated into German, Romanian, and is currently being translated into Chinese, Korean, and Spanish.
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