Dollar cost averaging… Sounds sophisticated. Sounds like one of those terms financial advisors use to intentionally confuse us and get us nodding our heads to believe they’re smarter than we are. But you know what? It’s really not all that complicated. Dollar cost averaging is actually fairly simple, and every one of us can put it into practice and benefit from it.
What Is Dollar Cost Averaging?
Dollar cost averaging is simply this:
Dollar cost averaging is an investment strategy where, instead of putting a lump sum of money into the market, an investor will invest smaller amounts of money over consistent periods of time.
Pretty simple right? If you’re investing in your company 401(k) plan and they withdraw funds from each paycheck to invest in the market on your behalf, you’re already dollar cost averaging! You’re putting consistent, smaller amounts of money into the market over consistent periods of time for the long-term.
Boom! Look at you! 😉
Here’s another example. Liz and I have two young kids. We want to send them to private school to give them the best start in life. The only problem…? It costs nearly $10,000 per year to send them to our school of choice… That’s $250,000 that we’ll be shelling out. Yikes!
Thankfully, Liz and I are both savers AND we both realize that if we start investing for their education sooner rather than later, we won’t have to dish out as much cash in the long run. In other words, by investing now, our money should make us more money that we can then use toward education.
So what do we do?
We dollar cost average of course!
Ever since our oldest turned one (and we started thinking, “Oh crap, we need to start paying for school soon!), we’ve taken $200 out of our bi-weekly paycheck and put it into the stock market (we believe in index fund investing – see the “related article” below if you want to learn more).
Since we started, the market has seen highs and lows, but regardless, we’ve continued to invest consistently and have “dollar-cost averaged” our way to over $30,000! It’s a nice start, especially considering that neither kid is in school yet!
Why Is It Important?
I’m sure you agree at this point that dollar cost averaging is a pretty basic concept, right? I mean, it doesn’t take a rocket scientist to understand how to put $200 into the stock market each week.
Does it really matter? What if I have $10,000 sitting in savings that I wanted to invest? Wouldn’t it make sense just to invest it all at once to reap the benefits of the stock market immediately?
Well…if the stock market always went up and up and up like a roller coaster on its initial assent up the track, then yes it would.
But the stock market doesn’t always go up does it?
Instead, the market is more like a roller coaster after it breaches that first big hill – it goes up, then down, then up, and down. It might even do a corkscrew along the way! Heck, even the greatest investors don’t know what the stock market will do on a day to day basis. They don’t know when it will reach its highs, and they don’t have a clue when it will reach its lows either.
What If You Don’t Practice Dollar Cost Averaging?
Right now, the stock market (as represented by the Dow) is at roughly 24,000 points. Let’s say we invest a lump sum of $10,000 today.
- And then…the market goes up to 24,500 points tomorrow
- The next day, up again to 24,750 points (Woo hoo! We’re making money!)
This is great! The market is up 3.125%, which means we earned $312.50 by doing practically nothing!
But then…the market decides to take a little bit of a dive – this time due to the student loan crisis (we’re making this up, but it’s not far-fetched).
- The Dow goes from 24,750 points down to 23,000.
- Then, a few weeks later, down to 22,000
- And then, after a few more weeks, it’s down around 20,000…
Our $10,000 investment is now worth $8,333. A loss of 16.67%… Not good.
Thankfully, the market strengthens and over the next year, and it shoots up to 30,000 points. (Again this is just a fictitious example, but it’s totally possible.)
Now, your investment is up 25% from its original value and sitting nicely at $12,500. YES! But…what if you had practiced dollar cost averaging instead?
What If You Embrace Dollar Cost Averaging?
In the above example, we just decided to plop $10,000 into the general market. It’s not a terrible idea since the market does tend to go up over time, but it just adds an element of risk, doesn’t it? (I mean, even if you’re gambling at the casino – which is already a high-risk event,- you don’t just walk in and place one max bet and then walk out, do you? Of course not! It’d be too risky.) By putting large amounts of money into the market at one time, you’re adding risk into the equation.
This is why many finance professional recommend dollar cost averaging – to reduce your inherent risk in the market, AND to give you the chance to earn more over a long period of time.
Why It Could Earn You More
Using the progression of the stock market in the example above, I’d like to show you why dollar cost averaging often gives you an advantage over those “one-timer” type investments.
Instead of plunking $10,000 into the market on day one (which, since no one can predict the market, is likely not the market bottom). Let’s say you put in $1,000 every week until you’ve used up your $10,000 – so, for 10 weeks. With the scenario above, what will your investment be worth vs. the one-time bulk investment?
Based on the chart above, the ‘dollar cost average’ investor not only out-earns the one-time investor at the 52 week mark, but earns nearly $1,000 (or 7%) more!
So why might dollar cost averaging earn you more?
It can seem a bit mysterious at first – since both investors are putting the same amount of money into the market – but after looking at the chart above, it should be fairly obvious why the dollar cost average investor earns more.
The market tends to go up and down. In the above example, the market goes down, then bounces back up. So, while the one-time investor is already fully in the market, when the market goes down, the slow, consistent investor is purchasing shares at a discount. Therefore, the dollar cost averaging investor is actually buying more shares than the one-time investor. So, in the end (in this example), with more shares, the dollar cost average investor comes out on top!
Dollar Cost Averaging in Today’s Market
As I write this post, the market is still a bit insane. Here’s a glimpse of what we’ve seen lately.
- Bad news comes out about job losses – the market goes up 400 points…
- President Trump urges people to get back to work, but safely so we don’t see another virus spike – the market goes down 500 points
- People are shocked to see bad quarterly results…even though businesses have been shut down for weeks – the market goes down 350 points
One really can’t tell when the market will rise or fall. Common sense seems to have little to do with day-to-day trading.
In other words, in the next 6 months, the Dow could fall to below 20,000. Or, it could bounce back and near that 30,000 record again. No one really has a clue.
So what do you do?
- Do you put small amounts in each week and dollar cost average?
- Or, do you take a chance and plunk large sums of money into the market when you consider it to be the bottom?
If you’re waiting for the bottom, we might be there already and you’ll forever hold onto your money while the stock market rallies to all-time highs again (I saw plenty of people do this while the market went from 14,000 in 2013 and stormed all the way up to 29,000! Boy, THEY missed out!!).
If you’re investing heavily now because you think this is the low, you could be wrong too – maybe the market falls and rises to no more than 24,000 for the next few years…
The point is, we just don’t know. And if it were me, I’d dollar cost average my way into the market! And you know what? I think I’m going to be laughing all the way to the bank!
Dollar Cost Averaging – Are You Convinced?
So what do you think? You now know…
- what dollar cost averaging is,
- why it might make you more money than if you just loaded a lump-sum into the market, and
- that it reduces your risk in a volatile market.
Unless you believe that you can predict the market (which we all know is impossible), then I can’t see why you wouldn’t rather load money into the market in consistent small increments.
Personally, I love dollar cost averaging. It keeps me at ease, it allows me to continue investing in the market even if it takes a dive or spikes without warning, and it will likely make me more money in the long-run! I’ll keep dollar cost averaging for many years. And, after reading this post, I suspect you might do the same.
Are you ready to start dollar cost averaging?
My name is Derek, and I have my Bachelors Degree in Finance from Grand Valley State University. After graduation, I was not able to find a job that fully utilized my degree, but I still had a passion for Finance! So, I decided to focus my passion in the stock market. I studied Cash Flows, Balance Sheets, and Income Statements, put some money into the market and saw a good return on my investment. As satisfying as this was, I still felt that something was missing. I have a passion for Finance, but I also have a passion for people. If you have a willingness to learn, I will continue to teach.