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Sunday, December 16, 2007

Introducing Favorable Bias into Dollar Cost Averaging . . .

We ended the discussion the other day, talking about a disadvantage to strict dollar cost averaging. A times, if you have a really strong stock, instead of lowering the dollar cost average of the shares you are holding, you actually increase them. As we discussed, strict dollar cost averaging means you invest in the market and stocks no matter what the conditions are at specific intervals throughout the year, say, every 3 or 4 months.

Is there a way to introduce a bias into dollar cost averaging so that we retain the benefits of reducing our risk, while at the same time trying to avoid the possibility of raising our dollar cost average on our strong stocks? Yes there is.

We combine the factors of seasonality, with dollar cost averaging. This does not eliminate the risks, but it does introduce a historical bias into getting the best price possible for our investments. If we use capital to purchase shares repeatedly throughout the year, and look for sesonal buy points throughout the year over time, we will probably receive a better price than if we were to use strict dollar cost averaging.

Let's illustrate. Here's a very rough chart of the S&P 500 Index on a seasonal basis.


Now looking at this chart, what would be the best times of the year to use our capital to buy a particular stock? We could pick the times of January, April, and the end of the year at November through December.

This is why people will often hear me state that I never invest in the market from July to November. Is this something that I so intelligently discovered?

No.

As you progress in your investing and trading career you'll hear various adages. One of them is "Sell in May and Go Away". It's understood that generally, though not always, the market tends to peak in May and June, and it's best to leave the market alone.

For our investment portfolio we are not looking at selling per se. But we are looking at the best times to accumulate shares. Therefore it's generally not best to buy into your investment portfolio from May 15th to November 1st. Of course, we have to consider what we've already learned about seasonality. Each year is different. 2007 is an excellent example. We didn't see the rally begin until the very end of November. But in general, if we consider the above chart when looking at times to purchase shares for our investment portfolio we'll be buyers around January, April, and the end of the year at November through December. We thus introduce a seasonal bias into dollar cost averaging in an attempt to obtain a better mean price.

In the previous entry we demonstrated that with a strong stock such as FRO, we would have ended up with a mean share price of $39.75 with 4 purchases of 40 shares a piece, or 160 shares.

Now let's try the same thing, but consider seasonality with the purchases.

We would buy 40 shares in January for $31.84

We would buy 40 shares in March for $33.50

On strength, we would have added 40 shares in April at the breakout, at $37.28

We would not buy from May to November 1st.

We would buy 40 shares in November at $39.92

Now, instead of a mean share price of $39.75 when using strict Dollar Cost Averaging? We have a better mean share price of $35.63 using Seasonal Dollar Cost Averaging.

I urge you to look over good, strong companies, and see what a difference seasonal dollar cost averaging can make over the long term.

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