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Dollar Cost Averaging
Investing can be an intimidating area of finance. We all know the market carries risk with it and who wants to lose money. The terminology and hundreds of products can feel overwhelming. One topic that is widely debated is when to invest. Odds are you have heard or seen when people attempt to time the market, or your coworker gives you a tip calling it a “sure thing, and get in now”. Even the professionals have trouble with this and that’s because no one has the magic crystal ball.
To help alleviate some of the stresses of knowing when to invest, you can adopt the strategy of dollar cost averaging.
What is dollar cost averaging?
You may be applying dollar cost averaging without even knowing it. Using dollar cost averaging methodology is when you decide on a specific dollar amount and invest it at the same time each month. That simple. For example, if you invest in your 401(k) plan, that is dollar cost averaging. Every two weeks (or when you get paid), you take a portion of your income and contribute to your plan. It doesn’t just have to be a 401(k) however, the strategy works great with regular brokerage accounts, IRA’s, or a college 529 plan.
The main idea is you keep your contributions consistent and it never hurts to gradually increase them over time.
The benefits of dollar cost averaging
Reducing emotions
One of the first benefits you will notice is doing this will help you take emotion out of the market. The market is often as much about behavior as it is about analytics. This is because if the market is up, down, or sideways, you will continue contributing no matter what. History has proved that long-term, passive investing rewards more than active investing. The goal is to simply get in the market and let compound growth work its magic.
Spreading out contributions
With dollar cost averaging you will sometimes be buying in at the optimal time and sometimes not so optimal time. If you stay consistent with your investment schedule what happens over time is you average out. This helps reduce your risk by spreading out the purchase intervals. Forbes has a great article on the topic and in the article shows you how the math plays out. So the next time you get a nice $1000 bonus and want to invest it, try putting $83 in each month over a year instead of the lump sum. This has been proven to be a more successful strategy that will build your wealth.
Timing the market
Another benefit to dollar cost averaging is you do not have to try and time the market. A lot of people try to time the market and buy in when it is low, but financial advisors know it rarely works for folks. If it isn’t your full time job, timing the market can be costly. We all have things going on making it difficult to watch the market every second. You miss a day or two and you might have already missed your opportunity. So if you are attempting to time the market, you might want to reconsider.
Market history
Lastly, you simply take advantage of long-term market growth. The market has many more positive years than negative years. If you do experience a year of negative growth, you simply entered the market at a discount for the year thanks to dollar cost averaging, all while your principal balance has grown over the last several years. Being out of the market is much more costly than anything.
Situations it may not be the best approach
There isn’t one size fits all situation with the market. A lot of people have become rich by buying stocks at the extreme low and then selling it at the right time. However, more often then not, people have lost money doing this. With that being said, if you have the time and like to research you may be better off timing the market. Another situation to not dollar cost average is if you only are investing for the short term. Dollar cost averaging takes time to work its magic. There is one final situation when not to dollar cost average. That is if you have a large sum of money. Maybe you just got $200k from a deceased relative. Well at this point, it is better just to get the money in the market then trickling it in over many years.
Conclusion
The best way to ensure you effectively implement dollar cost averaging is to automate the process. From time to time, you can revisit and adjust the contribution amount, but this way you never have to think about it. Take time to decide an amount and frequency, then like the old infomercial, “set it and forget it.”