DOLLAR COST AVERAGING | THE BASICS FOR NEW INVESTORS
What is dollar cost averaging and what do you need to know as a new investor?
This week we are going to thoroughly explore what it means to dollar cost average, how it differs from lump-sum investing and the pros and cons of both.
When things are uncertain in the world and we begin seeing big fluctuations in the market – it seems everyone has an opinion about what you should do with your money. Buy! Sell! Stay the course! It’s hard to know who is right without first understanding the risks and benefits of investing and what is best for your own circumstances.
What is Dollar Cost Averaging?
Dollar cost averaging is the act of investing a consistent amount of money in a particular investment vehicle over a period of time irrespective of fluctuations in the market.
One way you can dollar cost average is to transfer a portion of a large sum into an investment account on a regular basis. For instance, Jane receives an inheritance of $100,000.00. Jane is risk-averse and does not want to deposit the full amount into the market at once. Instead, she decides to deposit $10,000.00 a month over the next twelve months in her favorite stock.
A common form of dollar cost averaging is having a specific amount of your paycheck deposited into your 401(k) every pay period. In this instance, the dollar amount invested likely does not fluctuate greatly and occurs automatically on your paydays. The advantage here is that the focus is long-term.
Another example is Joe, who does not have a 401(k) but still wants to invest in his retirement. Joe deposits $200.00 out of every check into a Roth account which is invested in a mutual fund.
Each of these is an example of dollar cost averaging. The foundational principle is the same in each, consistent deposits over time.
How Does Dollar Cost Averaging
Differ From Lump Sum Investing?
Lumps sum investing is fairly straight-forward. It simply means a one time deposit.
In the prior example of Jane who received an inheritance of $100,000.00, if she were to deposit the whole amount at one time into her favorite stock, she would have made a “lump sum” investment.
The Pros and Cons of Dollar Cost Averaging
Mitigation of Risk
One of the greatest benefits to dollar cost averaging is that it protects the investor against the risk of bad timing of the market.
When you dollar cost average you are putting money into your investment accounts whether the market is going up or down. So, when the market drops you are buying more for less. Likewise, your dollars do not go as far when the market rises.
However, in the long run, the market has (almost) always gone up.
By investing consistently over time, you avoid the risk of investing all of your money and then having the markets drop dramatically at once. Ouch!
Dollar Cost Averaging Takes Emotion Out of the Equation
By having consistent and regular deposits, you take some of the emotional impulses from your investing. Chances are, if you dollar-cost average, you understand that markets rise over time and you are investing for the long term.
Given this, you are less likely to be influenced when there are big swings in the market or to jump on the band-wagon with the latest craze (remember Bitcoin).
Likewise, you also benefit when prices are down. You see this as an opportunity and because you are dollar cost averaging, you get to participate when things are “on-sale” too.
The Market Always Goes Up (most of the time)
So, while it is advantageous to be able to invest your funds when the market is going down, and dollar cost averaging allows you to take advantage of this, the disadvantage is that most of the time the market is going up.
According to the Motley Fool, in the last 50 years the market has been up and rallying three times the amount of time it has been correcting.
The god-father of the FIRE movement and author of the Simple Path to Wealth, JL Collins, would also agree, that the market is up far more than it is down (77% versus 23%).
Given that the market is up far more than not, if you are dollar cost averaging you will not do as well had you deposited a lump sum.
Should I Dollar Cost Average?
If this is true, then why dollar cost average?
JL Collins has written an excellent series (the Stock Series) in which he shares his investing strategy and describes how he has been able to accumulate wealth over the decades.
Neither Mr. Collins or myself are financial advisors, so we cannot tell you what to do with your money. You will need to decide that for yourself. In deciding, keep in mind the following:
If you invest a lump sum during a time when the market is on an upswing, you will earn more with your money than you would than if you dollar cost averaged with your money.
Advantage: You earn more with the same money than if you DCA
Risk: You time the market badly.
Dollar Cost Averaging with a Lump Sum
If you have a lump sum to invest and decide to dollar cost average, you will remove the risk of a large downturn in the market and have the advantage of being able to buy more when stocks are on sale.
The disadvantage is that the market is always going up (or at least most of the time) and as it increases, the price of stocks is also increasing and you will be able to buy less as time passes.
Advantage: Mitigates risk
Risk: The market always goes up, when it’s up, your dollar does not go as far.
Dollar Cost Averaging with Your Income
You may not have a large sum to invest and the major source, if not the only source, of your ability to invest is your income. If this is the case, do not fret. You still benefit from time.
Dollar cost averaging will smooth out the ride in economic downturns and the older your money gets the bigger it will grow. Investing in this manner is a long term game.
Advantage: Time is on your side. Mitigates risk. You don’t need a lump sum. You get to buy when the market is down.
Risk: Your dollar does not go as far when the market goes up.
With Dollar Cost Averaging I Can Set it and Forget it
In many ways, the convenience of dollar cost averaging, particularly if it’s done via payroll or automatic withdrawal, is that you don’t have to think about it. It’s done for you. You can “set it and forget it.”
Well, yes…and no.
Dollar cost averaging does not relieve you of the responsibility of checking in on your funds every now and then, of making sure you are in the best fund for your circumstances or that you have the appropriate allocation given where you are in your phase of investing (whether that is wealth accumulation or wealth preservation).
If you are new to investing, I highly recommend JL Collins book mentioned above and his blog. Another great resource is the MadFIentist. We have referred to both many times when we wanted to learn more about investing or related principles.
When we began our financial independence journey, we were beginners too. Not that we are experts now, far from it. However, because we have done as you are now, and educated ourselves about investing, we now feel comfortable and competent to make decisions about our money as we build our family legacy.
We believe you can too!
Love and Prosperity,
Wendy and Curtis
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