It seems like nearly every day the market is swinging up or down by five percentage points or more, and individual stocks have often went up or down by 10% or more in a single trading session. Now, if you’re like most investors, these up and down swings can lead to anxiety regarding one’s investment portfolio.
A Time-Tested Investment Strategy: Dollar Cost Averaging
However, the good news is that there is a time tested investment strategy that almost guarantees, guarantees you will build wealth over time. Now almost because nothing in life is 100% except taxes and debt. But this technique is called dollar cost averaging and it’s been highly successful over a long period of time.
What is Dollar Cost Averaging?
So you may be wondering, what is dollar cost averaging? Well, in a nutshell, it’s a simple investment strategy that will help most people build wealth over time. Alright, so dollar cost averaging is the process of investing the same amount of money in a particular asset over a consistent interval of time. So joe it all with the dollar cost averaging method. You invest the same amount every single time, regardless of the asset’s price. The goal behind dollar cost averaging is to reduce the effects of market volatility.
Now truth is, there are a ton of businesses every day that you can buy on sale. So you may not be able to buy the whole thing, but you can certainly buy a piece, and a small piece of the right business at even better prices will make you money over time. So even after you buy into a business, you want the price of the part you don’t own, the parts you haven’t bought yet to go down. That’s right, down, not up. If it goes up, we do good. If it goes down, we get rich. Now I know that sounds crazy, but remember, our net worth is not about prices, at least not in the short term. Our net worth is about value. If prices go down, but we know what we’re doing, our net worth is going to go up big time.
Advantage of Market Volatility
The biggest advantage to dollar cost averaging is that it spreads out your risk. For example, let’s say that you had $1,000 to invest in a stock that’s currently trading for $100. Now, if you invested all of your money at once, your $100 would buy you ten shares. But let’s say that you divide your thousand dollars into four equal investments of $250 spread out over four months. Here’s an example of how things could play out. So in this example, you would end up with 11.34 shares instead of ten shares at the end of the four month period. Now, those 1.34 extra shares would also mean extra profit for every dollar of future stock price grow. So that is the potential benefit of spreading out your risk over time.
Now a second advantage to dollar cost averaging is that they can remove emotion from the investing process. Truth is that just because a stock or fund has dropped 30% this week does not mean that it’s going to rebound by 20% next week or even next month or next year. Trying to time the market, trying to guess when to hop in and out of stock positions is tough even for investment professionals, much less the average Joe. But we aren’t the average Joe, are we? Anyway, joe it all another added benefit of dollar cost averaging is that it can keep you from panic selling when the market is acting wild. And to be honest, it can also help you resist the temptation to go all in on high risk speculative investment.
The Downside of Dollar Cost Averaging
Now that we’ve talked about the benefits, lets look at some cons of this investment strategy. So one of the downsides of dollar cost averaging is that the market tends to go up more than it goes down. So lets revisit our early example. But this time well see how dollar cost averaging can hurt you when the market is trending up. So as you can see, you would end up with 9.04 shares after the four month investing period instead of the ten you could have had if you’d invested all of your money at once. So what this example shows us, guys, is that while dollar cost averaging acts as a great hedge against bear markets, it will tend to underperform lump sum investing during long bull market periods. Long term S and P 500 data shows that bull markets have historically lasted longer and have been more pronounced than bear markets. So as you can see, the dilemma with dollar cost averaging is whether an investor is willing or even able to put in more money at exactly the time they most need to.
Is Dollar Cost Averaging Right for You?
Again, trying to time the market is always a risky game. For example, in 1930, a $500,000 portfolio went to 75,000 in one year. How many people had more money to buy in after that? So you may be wondering, is this the investment strategy right for you? It depends on your particular financial situation. But for the vast majority of people, it’s a safe long term investment strategy. Remember, there is a reason why it’s called personal finance. because truth is that many people don’t have a lump sum of money to invest. Instead, the vast majority of people plan to budget a certain percentage of their income each month towards retirement savings and investments. And for these slow and steady investors, dollar cost averaging their monthly contributions is a great choice. Now, even if you do have a lump sum to invest, dollar cost averaging could be a smart move during tough times of high market volatility.
The Psychological Benefits of Dollar Cost Averaging
Another added benefit is that you may find dollar cost averaging reduces your anxiety around investing and can you really put a price tag on your emotional mental health? And can’t stress the importance of just getting started. There’s something empowering about telling your money where to go. So by investing, you’re giving your dollars a job to do, which is to make you wealthier over time.