What is Dollar Cost Averaging?

admin // November 21 // 0 Comments

What if there was a way to build a secure future or even become a millionaire without the need to be an investment expert? There is a way, and it’s easier than you think. Like any great recipe, you’ll need a few key ingredients. Time is an important factor, as is compounding and also diversification, but the last ingredient is dollar cost averaging, the secret ingredient that makes everything smooth.

Dollar cost averaging refers to the idea of making steady investments without regard to price. At first glance, the idea of buying an investment without considering price might seem like a terrible plan. What if you pay too much? What if the market drops again?

In practice, however, dollar cost averaging is designed to take the guesswork out of investing. Let’s face it. None of us knows what the market will do in the short term. In fact, it’s that fear of the unknown that keeps many people from investing on their own. Maybe they’ve lost money in the past or maybe they know someone who lost everything trading stocks. That’s the primary difference right there. Dollar cost averaging isn’t trading. It isn’t about trying to time the market. Dollar cost averaging is a method of investing that smooths out the highs and the lows, taking the angst and guesswork out of building a portfolio.

The key to making dollar cost averaging work for you is to invest a fixed amount at set intervals. Let’s say you have $200 per month you want to invest. You might be tempted to watch the stock market shows and start reading the stock trading websites. One expert might tell you the market will go up in the next few months, while on another channel, a different expert is telling you the market will go down. Guess what? Neither expert knows for sure. They may be right in the short term, but you might also guess right by flipping a coin.

Instead of timing your investments or trades based on speculative data, dollar cost averaging dictates that you make the investment anyway, regardless of what the experts are saying, regardless of price, regardless of news, and regardless of what that little voice in your head is saying. If the price is lower, your $200 will go further. If the price is on the rise, maybe it will go up more in the short term — and if it doesn’t, you’ll be able to buy more shares later.

If you’re investing $200 per month in an index fund and the shares are at $10, you’ll be able to buy 20 shares. If the price drops over the next month and the price is now $9 per share, you’ll be able to buy 22 shares. The price drop is only a problem if you intend to sell right away.

Now, you’ve invested $400 total over 2 months and you have 42 shares with an average cost of $9.52. Unless we can predict the future, there’s no way of knowing with 100% certainty if the price will rise or fall. Even the best technical traders make the wrong call sometimes, some more often than others. By dollar cost averaging, you’ve more than doubled the number of shares you own and you’ve reduced your average cost. There might be a silver lining in those temporary market drops.

Dollar cost averaging looks at the long term

Instead of focusing on the daily or weekly gyrations in the stock market and its often fickle valuations, dollar cost averaging ignores the ups and downs. It ignores market exuberance and short-term panics. In a way, the dollar cost averaging approach to investing is similar to the tortoise in the old fable about the tortoise and the hare. The tortoise, while slower, bested the agile hare in a race because he never stopped moving forward, whereas the overconfident hare stopped for a nap.

All this leads to a natural question, however: If dollar cost averaging assumes that we don’t know the short-term direction of the market or of a given stock, then why should we expect we know the longer-term direction of the market?

History gives us the answer. While not a guarantee, the past performance of the stock market, when viewed as an average, can give us an idea of what to expect in the future. For example, the historical annual return for the S&P 500 since its inception in 1928 is about 10%. In the next year — or in the next 5 years — the S&P 500 may be up or down, varying from that historical return percentage. However, given enough time, it’s reasonable to expect an investment return that grows closer to the historical average return.

Dollar cost averaging reduces risk

There are two ways in which dollar cost averaging reduces risk for investors. One of the ways dollar cost averaging reduce his risk has already been mentioned: dollar cost averaging removes the guesswork from buying and selling decisions. Sometimes people get into trouble with investing by trying to time the market, following the old wisdom of: “buy low, sell high.”

Buying low and selling high, consistently making the right moves at the right time, is much easier to do on paper than it is in real life. The times where you do get the market timing perfect — or nearly so — can be easily negated by a few guesses that went in the wrong direction. It can be pretty frustrating to see your gains wiped out by a few market trades where the timing wasn’t quite right. Dollar cost averaging removes the downside risk by blending the average cost of your stock purchases, creating a smooth chart of rounded lines that represent your average purchase price over time. What you’ll find, in most cases, is that your average cost increases, which is a good thing because it means the value of your investment is also increasing.

Dollar cost averaging also reduces risk in a more subtle way, which is by keeping you invested in the market, preventing missed profit opportunities that come from sporadic investing or long-term investing hiatuses. A stock you don’t buy today is a stock you can’t profit from tomorrow. By enforcing a regular investment schedule and they fixed investment amount, your building a program for a secure future through dollar cost averaging.

Dollar cost averaging saves time and reduces stress

Think back to the last thing you had to learn that was completely new to you. Maybe you decided to take martial arts classes, never having thrown a kick before, or maybe you decided to do some home improvements — even though you had no experience and owned only a few simple tools. It’s likely that there was a long learning curve, and that you made some mistakes along the way. Investing has a similar learning curve, and mistakes can be costly.

Now imagine if you could invest like a pro, showing solid, respectable returns over time, and without needing to become the investment equivalent of a black belt or a master carpenter. Dollar cost averaging provides you with that opportunity because if you stay disciplined in you’re investing, contributing to your investment accounts regularly and without regard for short-term price movements, you’ll turn a respectable profit without needing to know all the intricacies of the stock market or of company valuations.

Additionally, dollar cost averaging reduces the stress involved with investing, forcing you to take a long-term view, and thereby not being rattled by the day-to-day movements of the stock market. When looking at the broad market, every downward move in stocks has been regained over time — and then some. Investors who panicked and sold their broad market investments during market swoons missed the opportunity to buy more and earn more.

Using dollar cost averaging with individual stocks

If there’s a single biggest risk that can be attributed to dollar cost averaging, it’s the risk that comes with buying individual stocks. The averaging concept is still the same when buying individual stocks. You would invest on a fixed schedule with a fixed amount of money, buying shares regardless of price. The risk isn’t in dollar cost averaging itself. Instead, the risk is in investing in individual stocks.

For example, let’s say your favorite internet startup just had its IPO, which is an initial public offering of stock. You hear that this company is going to do great things and that they have daring plans that could dramatically change the way we use the internet. Using dollar cost averaging, you would invest a fixed amount when the stock goes public and then continue investing a fixed amount every month thereafter. If your favorite internet startup company realizes its goals and revolutionizes the internet, you could do quite well.

However, if your favorite internet startup company runs into challenges, perhaps with adoption rates or with federal regulation, there’s a possibility that the company’s lofty plan never really gets off the ground. Maybe the company never makes a penny or is forced into bankruptcy after heavy infrastructure spending with essentially zero revenue. In this case, dollar cost averaging only helped by decreasing your average purchase price as the stock continued its freefall until it was trading for pennies. While the concept of dollar cost averaging is sound, the risk, in this case, was due to a lack of diversification. Whenever purchasing individual stocks as opposed to diversified funds, consider the money you invest to be at more risk — because it is.

Using dollar cost averaging with mutual funds or index funds

When investing in mutual funds or in index funds is when dollar cost averaging really shines. Let’s work with an example of dollar cost averaging for the S&P 500. You found a low-cost mutual fund that tracks the S&P and which allows automatic investing with automated bank debits every payday. You decide to invest $100 every week automatically, using a Roth IRA that allows tax-free growth and tax-free withdrawals when you reach retirement age. There are 4.25 weeks in a month, giving you an average monthly investment of $425.

By the way, you found this fund 10 years ago. Here’s what your performance would look like:

After 10 years of investing, with the market going up, down, and sideways, your total investment is $51,000. Because you set up an automatic investment and the money comes out of your bank account every payday, you don’t even miss the money. At the end of the 10-year period, your investment is worth $95,826. You didn’t have to be an investment genius or even pay attention to the market in any way. Your regular investment purchased shares like clockwork, buying more when the market is down and buying less when the market is up.

Let’s go back a bit further. Let’s assume you found this mutual fund 20 years ago. You’re investing $100 a week, $425 per month. There’s a big difference in this example, however. The market was flat or even down for many of the years in the prior decade.

Here’s what your investment would have looked like from February of 1999 to February of 2009:

Amount invested = $51,000

Final value of portfolio = $37,046

These are real figures based on the S&P performance during those years. But let’s add another 10 years to the example and see what things look like then.

In this case, you’re using dollar cost averaging to invest in your S&P index mutual fund over the course of a full 20 years, starting in 1999 and continuing through 2019.

Amount invested = $102,000

Final value of portfolio = $244,732

That’s a bit better. You’ve earned over $140,000 toward your retirement, plus your investment amount, which you contributed over time.

If you’re curious to see what happened historically, let’s go back another 10 years. This time you begin investing in your S&P index mutual fund back in 1989. You’ve been investing steadily for 30 years, with a monthly investment of $425. During this time, there were a few stock market crashes and a fair share of stock market volatility. However, you ignored all of it and kept investing on your regular schedule.

Here’s what you would have accomplished:

Amount invested = $153,000

Final value of portfolio = $665,396

That’s even better yet. You earned over $400,000 just by investing regularly, and without trying to outguess the market, which can be risky if you guess incorrectly.

Final thoughts

With dollar cost averaging, time is your friend, and by contributing to your investment savings on a regular schedule, you’ll be able to overcome short-term dips and even decade-long market swoons. You’ll have to stay disciplined, however. A short break can easily turn into a long-term hiatus that can cost you thousands or even tens of thousands of dollars over your investing career.

You can see how, with a large enough investment amount and enough time, it wouldn’t be difficult to retire as a tax-free millionaire. Eliminating as much risk as possible will help you to reach that goal and dollar cost averaging eliminates both the risk of guesswork and the risk of missed earning opportunities caused by not investing regularly.

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