WBS: Episode 16 – Dollar-Cost Averaging
There’s a lot of long-term value in automating your investment decisions and taking emotion and speculation completely out of the process. As investors, we tend to be our own worst enemies over time. Dollar-cost averaging is an investment technique that involves purchasing a fixed dollar amount of a particular investment and doing so on a consistent basis going forward – whether the markets are going up or going down. Rather than trying to time the market, investors are much better off following a rules-based approach and focusing their time and energy on savings rates instead of market sentiment or other investment speculation.
The Whiteboard Series is a continuous exploration and discussion across a wide range of personal finance topics. Through a series of drawings, interviews and explanations, we hope to educate and simplify important financial planning principles.
On today’s Whiteboard Series I want to talk about Dollar-Cost Averagingand the long-term benefits of automating your investment decisions and taking emotion and speculation out of the process.
Dollar-cost averaging is an investment technique that involves purchasing a fixed dollar amount of a particular investment on a regular schedule, regardless of price or what the market is doing.
So hypothetically, here’s the stock market over a 5-year period.
As someone wanting to save and invest money, you have a few different options about how you might go about this process.
One option is to speculate, look at market values and other technical factors and trying timing the market with your investment decisions. So the market’s going up here and you like it so you buy, it starts going down and you get scared so you sell, then you get back in here, and you sort of base your investment strategy of getting in and out of the market based on some of your own emotions and things you might read about or see in the news.
Timing the market, particular consistently over longer periods of time, is almost impossible and it’s probably not a worthwhile approach for most investors out there – professional investors included!
The other option is to automate your investment decisions and take emotion and speculation completely out of the process. That’s what Dollar-Cost averaging is all about. Under a dollar-cost averaging approach, you commit to a certain investment allocation, a dollar amount and time interval, and you execute that strategy consistently over time.
So, if you plan to save a $1,000 per month, you say on the 1stof each month, I’m going buy into this investment allocation and keep doing so consistently going forward. So, you buy here, here, here, here and you commit to this strategy over the long-term. There will be times where your $1,000 buys more of that investment, and there will be times when it buys less of that investment, BUT OVER TIME IT’S A MUCH MORE EFFECTIVE APPROACH than trying to time the market.
The most common example of dollar cost averaging is 401k savings. Just about everyone that saves into 401ks does so through payroll deferral. Every two weeks, they set aside 5% of their paycheck and they keep doing so week-after-week, month-after-month and year-after-year after year. Through this process, we see how relatively modest amount of money, invested consistently over time, can grow to these massive sums over a period of years.
Most investors would be far more successful if they followed this same approach for investing outside of their retirement plans. For some reason, when people then want to start saving and investing outside of their retirement plans, all of sudden investing is this game. What’s the market going to do? What are good stocks? Should I buy, should I sell? When in reality, if they just committed to this same approach as their retirement savings process, they’d do very well for themselves over time.
What I like most about dollar cost averaging is that it takes human emotion, speculation and temptation completely out of the equation. Technology has made dollar-cost-averaging very easy to do with investing, being able to link your bank accounts to your investment account and setting up recurring savings.
I read a good overview of Dollar Cost Averaging that encouraged the mantra of Just Keep Buying. In rising markets, in falling markets, in sideways markets. Markets tend to go up more often than not and if you enter the market often and hold your investments over time, you’re going to benefit tremendously from adopting this Dollar Cost Averaging approach.