How Dollar Cost Averaging Through Life Reduces Risk

It is my contention that there are two ways that the average investor at home can gain an advantage over the algorithms, institutional investors, bankers, traders, and every other nebulous entity that we include in the definition of “Wall Street.”

My first conclusion is that investors can make money if they choose to embrace volatility. Whether it be oil stocks, media stocks, or financial stocks, certain sectors of the economy are prone to quick and sudden shifts that result in quick 30% rises or falls in their stock prices due to the recency bias that is created upon examination of a company with a cyclical business model (in other words, we overweight recent earnings results in performing expecting calculations of what the future for the business will bring.)

My second conclusion is that investors can make money by having a longer time horizon than everyone else. There are very few people out there, and I’ve been lucky to build an audience that is the exception to the general rule, who make decisions in 2018 with an expectation of a payoff sometime in 2038.

But when you enter the stock market, you are getting involved with publicly traded businesses that have buyers and sellers that have a much shorter time horizon than you do. What’s the average mutual fund holding right up to right now, something like three months? Even Vanguard actively managed funds have a 20% turnover rate, suggesting an average holding period of five years And, of course, there are computer algorithms that trade stocks in a non-stop fashion where the time horizon is just a few seconds away.

When you invest with a short time horizon, you have to get two things right—what will happen, and when it will happen.  That is an extremely difficult feat to accomplish because you have to step outside of yourself and guess how other people will process information that you must also predict.

I have no idea how you would do that. I have seen companies dramatically miss earnings expectations, and fall by less than a percent. I’ve seen other companies perform in line with analyst consensus estimates and the stock pops 6% in after hours trading. Short-term investing would be lucrative if you could pull it off—it’s just that the tax code isn’t favorable and it is really hard to guess exactly how others will process a given piece of information.

On the other hand, it is much easier to guess what will happen. I remember after the financial crisis, I saw that Bank of America’s dividend was slashed to a penny. The reported earnings in 2010 and 2011 were much higher, so all that cash was bolstering the balance sheet because it wasn’t going out the door to shareholders. Also, the “normalized earnings” appeared to be much higher than reported earnings because the company was paying so much in legal settlements that arose from Countrywide’s financial procedures in the years leading up to the financial crisis.

It became clear that the Bank of America dividend was bound to rise. If I had to guess when the dividend would raise, I would have guessed early 2012. Well, the dividend didn’t get raised to $0.05 quarterly until the payment in  September 2014, and it didn’t rise again to $0.075 until the payment in August 2016. That took a few years longer than what I anticipated. If I had to make decisions that hinged on timeliness for success, I would never be able to make money anywhere. But if I can just focus on guessing *what* will happen and can develop the patience to ride it out for years if need be, I now have an advantage because many other people are bound by institutional, political, and temperamental considerations that prevent them from structuring their lives so they only have to get the “what” part right.

When you see a stock price move 10% to 20% in short order, it does not mean that your investment is doomed. There are people you encounter who act like a business must die and cease to exist if it doesn’t experience in capital appreciation within the first year or two that they own it. That’s not how it works—if the profits are still coming in, and the debt payments are getting made, the business will exist perpetually as long as that premise holds. People forget that when they use recent stock price performance as a proxy for business performance.

But these stock-market swoons are just people with short term horizons readjusting their expectations for the next quarter or two—and sometimes, not even that. When you purchase any kind of interest in something that is publicly traded, you must first recognize that every other individual owner of that publicly traded security has a time horizon that is different from your own.

That is why you saw Nestle languish in the $60s and low $70s for so long. Analysts were regularly saying: “Everyone can tell that this stock is going to deliver total returns of about 10% annualized, and this is obviously one of the best risk-adjusted returns in the 2014 to 2016 stock market.” So why wasn’t Nestle going up neatly by 10% each year if the investor community had such a wide consensus that Nestle would grow earnings per share by 7% and give shareholders a 3% dividend along the way? Because not everyone was valuing the business over the subsequent 25 years.

In the near term, Nestle sales were flat-lining or delivering 1-4% sales growth and 3-4% earnings growth annually. For people that bought Nestle stock with the intent of holding it for less than year, the analyst consensus was irrelevant and the focus of the inquiry was on what Nestle would do in the months that followed. An investor with a three-month time horizon could be rational selling Nestle stock for $73 in the mid-2010s while an investor with a 20+ year time horizon could be rational purchasing the stock at the exact same price.

 

Throughout life, you will always hear people respond to a good idea that you might have with the phrase: “Well, if it’s so brilliant, why doesn’t everyone else do it?” There are a variety of valid responses to such a question that doesn’t address the merits of the discussion but instead calls upon you to prove a negative involving human psychology, but one of the reasons is that Idea X takes Y amount of time to execute and it won’t do so at constant Speed Z between the starting and end point of the journey.