What is dollar cost averaging?
A key part of my plan is dollar-cost-averaging, which is basically purchasing a fixed dollar amount of an investment asset on a regular basis.
Earlier, I described how I was going to set aside $240 every two weeks to purchase company shares. Plain and simple, that’s what dollar cost averaging is.
There are some huge advantages of this method that might not be apparent to you right off of the bat.
Obviously the targeted investment is going to move up and down in price every single day. By investing a fixed dollar amount every two weeks, you are naturally going to end up buying more shares when the price is lower and less shares than when the price was higher.
Let that sink in!
If instead, your goal was to buy a fixed amount of SHARES each two weeks, you are setting yourself up to have a higher average cost!
If the price is high at the time you need to make the purchase, you have to put up more money to buy the same, fixed amount of shares at that time.
If the price is low at the time you need to make the purchase, you don’t have to use as much money to buy the same, fixed amount of shares at that time.
In essence, you are spending more money at a higher price and less money at the lower price.
Wouldn’t common sense tell you that you want to buy more of something when the price is low and less of something when the price is high?
Of course! And that is what dollar-cost-averaging does for you!
You will have a lower average cost…automatically.
Also, imagine that you had a decent amount to get started on your path towards your financial independence….perhaps $5,000.
If you plunked that all into a stock all at once at a certain price and the next week the price fell by 10% and the week after that, another 10%…you would be pretty pissed off at yourself, right?
Instead, if you divided it up into say $1,000 increments over a period of time, you can’t kick yourself. The price could also go up, and you would be happy to know you at least had some money in the stock. The price could go down and you would be happy to know that you still have money on the sidelines.
Dollar Cost Averaging vs. A Lump-Sum Purchase
If you do some research… some searches on Google about dollar cost averaging, you will see pro and cons about it. The primary knock on dollar cost averaging is frequent studies that show that over any given 15 year period, it would be better to invest everything at any given time in one lump-sum purchase. This is certainly true.
It’s easy to pick and chose a timeframe to show how a lump sum investment beats dollar cost averaging.
For example, below is a sample chart of a lump-sum purchase vs dollar cost averaging for a sample period of time.
Clearly, had you plunked $100,000 into the S&P 500, you would have well outperformed the dollar cost averaging method.
But let’s pick another period of time…this one right during the “Great Recession” of 2008:
Here, dollar cost averaging well outperformed a lump sum investment of $100,000.
This was because you would have been purchasing a fixed amount of the S&P index on a regular basis as it plummeted hard during the downturn, buying more and more shares…cheaper and cheaper and cheaper.
With dollar cost averaging, when when the market started to recover, you broke even after 1.5 years and showed a huge profit after the 5 years.
With that lump sum investment, you were at a loss for almost all of the 5 years, finally getting to near break-even after the 5th year.
Advantages of Dollar Cost Averaging
Let’s just say this….dollar cost averaging will REDUCE your returns. That’s a fact. You can look at any 15 year period in the U.S. stock market and find that if you had invested a lump sum amount, you outperformed dollar cost averaging.
Fine.
Advantage 1: Starting small
So who has $100,000 sitting around to plunk into the market? If you do…great! I didn’t. You know from my story that I freely share, I started with nothing in my taxable accounts. I had no money saved for a rainy day. I had no choice but to dollar cost average.
You don’t need to have a ton of money to dollar cost average. You just “pay as you go”
Advantage 2: Less Worry
If I had $100,000 to start out, I would then have to make my investment picks right there and plunk that money somewhere, right? When you do that, you are going to wonder and watch each up and down movement with worry. You will wonder if you made the right investment choice. You will worry that your investment will crash, that the stock market would crash.
Advantage 3: Learning as you go
Also, when you are just starting out, you are still figuring things out, still putting your investment plan to the test. You are learning as you go. The investment choice you made with a lump sum investment, might not be the investment choice you would have made after you really started to fine tune and hone your investment acumen. Perhaps the choice you made one year earlier with the lump sum investment would not have been what you would be choosing one year later.
You can adjust. You can stop dollar cost averaging into an investment that didn’t turn out to be ideal and pivot elsewhere. Since the amount of your investment principal is spread out over time, let’s say a period of 5 years…if you decided after 6 months that the investment choice wasn’t ideal, and had lost money, you can pivot and invest in something else. You have only spent 6 months on a poor investment choice…with another 4.5 years of investment contributions in front of you if you were to move on to a better investment.
Advantage 4: You are forced to focus on the process not the money
Let’s face it, when you start out dollar cost averaging, you are starting small. That doesn’t feel so great in the beginning. I know you would prefer to start with $20,000 or $50,000 so that you can really make some significant dollar returns. Who wouldn’t?
However, in that case, your focus is entirely on how much money you are making.
When you start small, the returns aren’t that exciting from a total dollar amount perspective. Let’s say your first purchase eventually was up by 50%. Well, then you now have a $120 profit. Not the most exciting, right?
However, the advantage here is your focus should more be on the percentage returns. Focused on the process of making the right investment choice. Focused on doing the fundamental research. Focused on fine tuning your process.
Look at how this $240 each two weeks has grown for me! It didn’t feel like much in the beginning, but with time, patience, a plan, a goal, you will get it done.
You can do this!
Over time, the money will come. Have faith. Trust in your process. Put your head down and do the work.
I can tell you that I did exactly that and have finished ahead of my 4 year goal to accumulate $100,000. I did that by starting small, with $240. You can start with $25, $50 or $100. It doesn’t matter. Just do it…dollar cost average and you will be surprised at where you will be when you look back!
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