Dollar-Cost Averaging Down

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April 3, 2002

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IvoryJester says:

"Myself, I was at an average of about $47 and bought 150% more stock at $14.38 and was able to average down to about $27. Now at almost $17 I have started gaining back some of what I was down."

Let's take a closer look at this logic.

Let's assume that the Jester owned a 100 shares of CSCO at $47 and bought 150 more at $14.38. (It doesn't matter what the actual numbers are as long as the percentages are right.) Therefore, the Jester now owns 250 shares with a total exposure of $6857 (100 X $47 plus 150 X $14.38). His cost average is $27.43 per share. In other words, for the Jester to break even on this investment CSCO will have to rise 61% from today's price of $17. That's quite a jump given present market conditions. Also, even with a 50X P/E multiple CSCO will have to earn $.55 a share to be worth $27.43. Current projections show that CSCO isn't expected to hit that target for at least two more years.

Now suppose the Jester sold his original 100 shares at $27 and took a $2000 tax loss. I don't know what his financial circumstances are but I'd have to believe he would have reduced his 2001 tax liability by some amount...let's say $500. In other words, by selling and taking a loss the Jester would have salvaged $2700 of his original capital, plus $500 in a tax benefit, for a total of $3200. Then when CSCO hit $14.38 he could have stepped back in and bought 223 shares with his $3200, only 27 fewer shares (11%) than he currently owns but at a much lower risk (46% less...$4700 vs. $6857). And CSCO would only have to rise $21...not 61%, to break even on his entire investment.

So there you have it. Dollar-cost averaging while a favorite stock is falling is not always a good idea (most of the time it's a very bad idea). It's usually better to take a loss and salvage some principal. You never know when you'll be able to put that salvaged principal to better use than watching it sink to new lows.

In the case of CSCO, I remain convinced that the stock will touch $10 before it ever sees $27.


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