Dollar cost averaging: A simple and proven method of investing for the long term
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| Use dollar cost averaging to grow your money |
Warren Buffett: “The most important quality for an investor is temperament, not intellect. You need a temperament that neither derives great pleasure from being with the crowd or against the crowd.”
One of the biggest contributor to us (my wife and I) successfully becoming financially independent and retiring early, was our use of company sponsored retirement account, the 401k. Besides automating the savings process where a set desired amount is put away each paycheck, the 401k also has a major benefit of reducing taxable income during the working/earning years.
While some people may consider 401k to be a success while others may consider it to be a failure, it’s our job as individuals, to learn to use this tool to our advantage. In life, there is no perfection. Everything will have its pros and cons.
Learning to accept the limitations while understanding the benefits is the attitude we all should take when it comes to 401k. I can personally attest to the 401k being a great tool, if you learn to use it well…
In this post, I’d like to discuss the strategy of dollar cost averaging.
What is dollar cost averaging?
Dollar cost averaging is an investment strategy in which an investor divides up the total amount to be invested across periodic purchases of an asset to reduce volatility. The purchases are made regardless of asset’s price and they’re made at regular intervals.
Here are some examples of how this works:
Let’s say you get paid biweekly (every 2 weeks), you’re putting away $500 each paycheck, and you’re also buying shares of S&P 500 index fund.
1st paycheck ($500) | S&P 500 index fund share price for that week at ($250) | You bought (2) shares
2nd paycheck ($500) | S&P 500 index fund share price for that week at ($230) | You bought (2.17) shares
3rd paycheck ($500) | S&P 500 index fund share price for that week at ($260) | You bought (1.92) shares
4th paycheck ($500) | S&P 500 index fund share price for that week at ($240) | You bought (2.08) shares
Total amount invested ($500+$500+$500+$500=$2000)
Shares purchased (2+2.17+1.92+2.08=8.17)
Because the share price of the S&P 500 index fund constantly fluctuates, you’re buying them at different prices ($250, $230, $260, and $240). The end result is that you have purchased 8.17 shares. To calculate the average share price, divide total amount invested ($2000) by number of shares bought (8.17).
More importantly, you have paid on average $244.80 per share.
As a comparison, if you had decided to purchase $2000 worth of the same share at one time at $250 per share, then you would have exactly 8 shares. By using dollar cost averaging in our scenario, you’ve purchased 8.17 shares rather than 8 shares.
Pros of using dollar cost averaging:
- It allows you to purchase share(s) of an asset at regular intervals, rather than buying it one time, reducing risk and volatility. *Let’s say you decide to purchase this asset and you happen to buy when it’s at its highest price. The next day, you may lose money if share price goes down.
- As seen in our example above, you may end up with more shares when price of a share goes down when you made your purchase(s). In a down market like 2018, you would’ve bought more shares at discount of around 6% as S&P 500 index was down by that figure.
- Automated saving every paycheck is a good thing. If you’re a procrastinator, this ensures you’re still putting money away every two weeks.
- Emotionally, it may be easier for some investors to use this approach rather than buying one time, for fear of making a mistake.
- Because market tends to go up over time, it may be beneficial to buy using lump sum (one time) rather than buying regularly. *This scenario is only true if we’re talking about brokerage accounts or IRA/Roth IRA. In a 401k, you don’t have a choice…
- If investing using a brokerage account, there may be additional fees to buy shares regularly, whereas buying one time means one time fee.
Should I use dollar cost averaging when investing?
When investing using a company sponsored retirement account like the 401k, you are already using dollar cost averaging method. It takes the amount you specify, usually a percentage of your pre-tax paycheck amount, then buys shares of assets you selected every two weeks or so.
For example, let’s say your pre-tax paycheck amount is $2000. If you specified 15% to put away each paycheck, then that amount would be $300. (2000 X .15=300)
In this example, your employer’s 401k company would buy $300 worth of shares of an asset(s) you’ve specified every two weeks, if on biweekly pay schedule.
What if I don’t have a company sponsored retirement account like the 401k?
You can use this method if you have a brokerage account or have an IRA/Roth IRA. You can set aside money to invest regularly (withdraw from your checking or savings account automatically), usually monthly.
I have a lump sum that I can invest right now. Should I still use dollar cost averaging?
This is a personal choice. If you’re the type of person who gets emotional about making decisions, fearing you might make a wrong decision, then dollar cost averaging is the way to go. If you would rather break up the amount because this lump sum is also part of your emergency fund, or you need access to this money soon, then yes, you should use this method. *I’m a firm believer in having an emergency fund. You should keep investing money separate from your emergency fund, if at all possible.
Like anything in life, there will be exceptions to the rule. Figure out what type of investor you are, then make your choice.
Personally, if I had a lump sum to invest right now, I’d buy it one time. There have been many studies that have shown one time method usually comes out ahead, due to the market’s tendency to rise over time…This statement, however, is only true if you plan on holding it for at least 14 years or longer. ***The reason for the 14 years is because you would NOT lose money when holding it over this period, according to historical data.
In conclusion:
Dollar cost averaging is a great tool to use to achieve financial independence. It forces saving automatically and regularly, and it may allow you to acquire more shares of an asset.
Remember to follow good investment strategies like investing for the long term, buying mutual funds/index funds (not individual stocks), and always buy shares whether or not the market goes up or down.
Using a 401k allowed us to retire early and to achieve financial independence. Learn to use this financial tool to your advantage, and constantly learn about finance and investing.
Good luck in your early retirement and financial independence journey!
We thank you all for reading!
Jake
Wandering Money Pig
Please check out our YouTube channel ‘Wandering Money Pig’ showcasing our travels and our Pomeranian dog! https://www.youtube.com/channel/UC3kl9f4W9sfNG5h1l-x6nH
