Buying in Thirds: Does It Work?

Daniel is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Many investors recommend that you buy in thirds when you open a long term stock position. This strategy gives you mental relief by avoiding an "all-in" feeling on one large investment. You can be sure of one thing: Stock prices will change constantly. When buying in thirds, you can rest easy knowing that if the stock value drops, you'll be able to increase your position at a lower price. If the value rises, you can wait to use the cash for better opportunities. Seems like a win-win.

Does the theory actually work? Well, yes -- depending on how you define "work."

It's time to get nerdy, tape up the glasses, and dig in with a scientific approach. This experiment begins with a random sample of 50 stocks representing small, mid and large caps across all sectors and industries. To make things simple, two things were compared:

  1. Returns from investing in one lump sum.
  2. Returns from investing in three allotments.

The dates of investments are as follows. 

  • First: Jan-5-2010
  • Second: April-1-2010
  • Third: July-1-2010

Lump sum investments were made with $3,000. When buying in thirds, our experiment invested $1,000 at a time.

After extensive work in Excel, it's possible to conclude how the two strategies did compared to one another, as well as the S&P 500. All positions were ended Oct. 26, 2012.

The results

  • Buying Once Strategy returns averaged 44.3% (S&P 500 24.62%)
  • Buying in Thirds Strategy returns averaged 38.78%
  • In eight of the nine times when both returned negative, the Buying Once Strategy lost more value
  • In 30 of the 41 times when both returned positive, the Buying Once Strategy gained more value

<img src="/media/images/user_13516/thirds_large.jpg" />

The graph makes it easier for you to see. I said it worked, right? Why, then, did the Buy Once Strategy outperform in the comparison? The Buy in Thirds Strategy deviates from zero far less than its rival, making it less volatile. Like portfolio diversification, buying in thirds aims to protect investors from losses.

Here are specific insights with examples before the final conclusion is drawn. The tables below show examples of the results.

<img src="/media/images/user_13516/thirds_1_large.jpg" />

In this instance, buying in thirds was able to help ease the pain of significant losses by AK Steel Holding (NYSE: AKS) and Arch Coal (NYSE: ACI). With the slowdown of the global economy there was much less demand for steel causing AK Steel and investors alike to suffer losses. 

Arch Coal, with the rest of the coal industry, suffered alongside steel companies as there was less demand for coal in the steel creation process. In addition to that, record low natural gas is giving energy plants good reason to switch away from it's high emission counterpart. AK Steel and Arch Coal saw a drop in value so drastic that buying in thirds helped protect investors only slightly. In less drastic situations, buying in thirds would help protect you more.

<img src="/media/images/user_13516/thirds_2_large.jpg" />

Here are two examples that show the positive end of the spectrum. Buying in thirds of a great company won’t diminish your returns too harshly. Apple (NASDAQ: AAPL) is a great example of how steadily putting money into an innovative company will lead to high returns over time. When you identify a great company, don't be afraid to continue adding to your position. A company with a competitive advantage will continue to dish out high returns.

Expedia (NASDAQ: EXPE) provides a fantastic example of buying a great company before the market catches on. Buying in thirds creates your initial vested interest, allowing you time for further research, while waiting for your next buying opportunity. If you’re a value investor, buying in thirds would be a great adjustment to your strategy to earn higher returns.

<img src="/media/images/user_13516/thirds_3_large.jpg" />

It’s only fair to highlight a worst-case scenario for the Buying in Thirds strategy. Let's call it "The Roller Coaster": buying a fast growth stock in thirds as it increases sharply in value, and then watching as it crashes to the floor. That’s exactly what happened to Netflix (NASDAQ: NFLX) during the timeframe of this experiment. Put yourself in the best position to make decisions by analyzing and researching your stocks often. With a little luck, you can avoid an event like this roller coaster example.

The Cons
There are drawbacks to every investing strategy. For a buying in thirds strategy, the business term opportunity cost applies. In theory, the stock market steadily rises over time, causing your cash sitting on the sidelines to lose potential value it would otherwise have gained. It’s fair to say the Buy Once Strategy gained 5.52% over Buying in Thirds Strategy, partially due to the opportunity costs of waiting 6 months to finish the position.

Bottom Line
Buying in Thirds can be a good investing strategy. However, when some investors hear about a “good” strategy, they often assume that means higher returns -- which aren't the goal in this case. Buying in thirds helps you invest better by spreading out your entry price, effectively hedging against price volatility. Simply put, buying in thirds does for you on a small scale what portfolio diversification does on a large scale.

Now go help the world invest better and pass it on!

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dmiller5350 has no positions in the stocks mentioned above. You can follow Daniel on Twitter @StreetSmartFool. The Motley Fool owns shares of Apple and Netflix. Motley Fool newsletter services recommend Apple and Netflix. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.If you have questions about this post or the Fool’s blog network, click here for information.

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