Dollar cost averaging represents a powerful way to systematize your investing process and eliminate emotional reactions to market swings. This post provides an overview of the strategy and explains how you can implement it today.
Introduction
If pressed to describe the stock market’s recent activity in a single word, I’d go with “turbulent.” The narrative around rising interest rates has sent high-growth darling tech stocks on a roller coaster ride. The Suez Canal blockage threw a wrench in the global supply chain. And after years of mediocre returns, small cap value stocks are booming again in 2021.
What does it all mean?
I don’t really know.
And here’s the thing…
I don’t really care. I don’t need to.
I’ve implemented a system that ensures I’ll be in a strong long term position no matter what the market does today, tomorrow, next year, or in 30 years.
This system is called “dollar cost averaging.” It allows me to remain focused on long term gains without troubling myself with inevitable market fluctuations and daily pandemonium.
In this post, I’ll provide a quick outline of what the strategy entails, then explain how how to put it into practice.
Fun fact. If you followed the advice in my bulletproof plan to wealth and invested using a 401K, you’re probably dollar cost averaging without even knowing it.
What is Dollar Cost Averaging?
Put simply, dollar cost averaging means dividing the total amount of money that you intend to invest into equal chunks. Then, investing each of these chunks at regularly scheduled time intervals.
Importantly, for dollar cost averaging to work its magic, these investments must be “non-negotiable.” Regardless of market conditions or life circumstances, think about the implementation of a dollar cost averaging plan like signing a binding contract with yourself.
The goal? Mitigate exposure to volatility and market fluctuations by spreading investments evenly across time.
The strategy smooths returns compared to investing a lump sum at a single moment. Since dollar cost averaging specifies a pre-set investment amount, your dollars will buy more shares of a stock when the market is down (price per share is cheaper) and less shares of a stock when the market is up (price per share is more expensive).
Beautifully simple, right?
Consider the most fundamental point of investing in the first place. Every investor simply hopes to buy for a cheaper price than they sell. But trying to outsmart the market and time this precisely is near impossible. Instead, dollar cost averaging removes uncertainty from the equation. It optimizes the process with a formulaic approach. It allows investors to win not with luck, skill, or intellect, but by virtue of discipline and commitment to a framework.
Dollar Cost Averaging Example
Here’s a quick example to illustrate how dollar cost averaging works in practice:
Joe has $20K that he wants to invest in the stock market. He decides to dollar cost average his investments instead of investing it all in a single chunk. First, Joe must decide the length of time he wants to spread his investments across. This will dictate the set dollar amount he invests at each period. Say he chooses a 5-month total time horizon with an investment made twice per month.
- 5 months * 2 investments per month = 10 total investments
- $20K total investable assets / 10 total investments = $2K per investment
- This means Joe will invest $2K, every two weeks for a 5-month period, until the full $20K has been deployed into the market
Alternatively, Joe could invest the $20K on day 1. Theoretically, the market could immediately skyrocket by 50%, making Joe’s investment worth $30K on day 2 (YAY). Or it could immediately tank by 50%, making Joe’s investment worth $10K on day 2 (YIKES).
Notice the way dollar cost averaging would minimize this effect. Using the strategy, Joe would have invested just $2K on day 1. This means the 50% increase or drop would only result in a $1K net impact.
My Dollar Cost Averaging Plan
I maintain a perpetual pool of savings that I earmark for stock market investments. It’s comprised of funds that I save from regular paychecks, performance bonuses, one-off windfalls, etc.
The key is that I’m always working to replenish it…so unlike Joe’s example above, my preferred dollar cost averaging time horizon is essentially infinite. On an annual basis, I reset the fixed amount of money that I invest as my income grows.
With regards to the time interval, I invest once per week (every Monday) in low-cost, diversified index funds. Some would consider this frequency overkill.
However, I enjoy the act of investing and interacting with my money. It allows me to feel “active” even though I’m investing in a very passive manner.
Most importantly, the strategy helps me sleep at night. I’m a net buyer no matter what happens in the world.
When the market rises, I grow richer. Sure, my preset investment amount will buy fewer shares that week, but I’m happy to see my overall net worth climb. When the market sinks, stocks become “cheap.” Sure, my overall net worth might decline that week, but my preset investment amount will buy a larger number of shares.
And that’s the true reason I love this strategy: for the mental resilience and commitment that it inspires within me.
Oftentimes, the ability to stick to a financial plan (almost any plan) is more important than the specific strategy you choose. So craft an actionable plan that inspires that resilience and commitment within you. Then, pursue it relentlessly.
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