What is “Dollar Cost Averaging”?
We all know the old adage “buy low and sell high. Everybody knows the easiest way to get rich is to buy an investment at its absolute lowest value and riding the wave back up to the top, where you sell for an unbelievable profit. Rinse and repeat a few times and you’re rich.
If that’s the case, then why aren’t you rich? The answer is because people are terrible at knowing when investment prices have peaked and when they have bottomed out. I think the best financial decision I’ve ever made is fully embracing the fact that I know nothing (despite 2 degrees in economics) about how stock prices are going to look tomorrow and embraced the concept of passive index-fund investing.
Whether you have chosen to invest in index funds, regular mutual funds, bitcoin or individual stocks, the fact remains you likely have little to no insight on what prices are going to look like a year from now or (probably) even a day from now. This is why many investors turn to Dollar Cost Averaging. Dollar Cost Averaging is the strategy of investing a specified amount over a periodic schedule.
An example of dollar cost averaging would be investing $100 per month into a stock portfolio. Whether prices are high or prices are rock bottom, the investor continues investing $100 per month into their portfolio.
Most people don’t have the luxury of having large sums of money sitting around they could invest in a lump-sum so we have no choice but to follow a Dollar Cost Averaging strategy. But let’s say you came into $10,000 through an inheritance, how would you go about investing that new found money?
Some people (myself included) would be comfortable taking the full $10,000 and sticking it in the stock market straight away. Not everybody is comfortable with that level of risk. Nobody wants to be the person who invests their life savings the day before the market crashes.
The 2008 financial crisis is a perfect example to illustrate the case for Dollar Cost Average Investing. Let’s say you receive that $10,000 inheritance on August 1st, 2008. The S&P 500 is down about 20% compared to the same time in 2007 and you might be thinking to yourself, “Wow, what perfect timing, I can get these stocks at a discount!” So, you go all in, investing the full $10,000 right away. Within 6 months your $10,000 is worth less than $6,000.
(Narrator Voice: If you held onto that investment and had the courage to ride out the turbulence, your $10,000 could be worth over $26,000 today, but that is a story for another day.)
In the world of finance, there are so many formulas and equations and acronyms it can be very intimidating for regular…medium.com
What if, Instead of investing the full $10,000 on August 1st, 2008, you decided to follow the dollar cost average approach and invested $1,000 per month over a 10 month period? The first 6 months, you would still take a massive hit on your investments. However, not as massive as the scenario where you invested the full $10,000 on the eve of the crash. In fact, by February 2009 the market would have hit its absolute bottom and you would still have $4,000 left to invest over the next 4 months at historic discounted prices.
Dollar Cost Averaging is not a perfect investment strategy.
Narrator Voice: there is no perfect investment strategy
Remember when I said we have no idea what will happen in the stock market tomorrow? For all we know, If we invest $10,000 today it could be worth $20,000 in a month. Dollar cost averaging can mitigate some of the risks of a sudden market crash, but could also keep your cash on the sidelines and miss out on a sudden market spike.
Personally, I am a reluctant follower of the Dollar Cost Average strategy. Simply because I do not have large sums of money lying around to invest right away, so I have automated a certain amount to be withdrawn from my chequing account into my investing account each pay day.
This article is for informational purposes only, it should not be considered Financial or Legal Advice. Consult a financial professional before making any major financial decisions.