Dollar Cost Averaging: A Powerful Investment Strategy
One aspect of stock market investing that every stock investor should take a closer look at is their long term investment strategy. Many seasoned investors are constantly on the lookout for the most powerful investment strategy in their quest to become a successful investor.
Investors will search for years trying to find the best strategy, so we wanted to share more about a strategy with you that could totally change your outlook on investing. One candidate for the most powerful investment strategy is Dollar Cost Averaging (DCA).
What is Dollar Cost Averaging?
Dollar cost averaging involves investing the same amount of money at regular intervals into the same financial asset.
As it turns out, if you invest the same amount each time, you buy more of something when the price is lower and less when it’s higher.
Interestingly, this means that at the end of the period you will have an average price paid (average cost basis) for what you own that is less than the average price of that thing over the same time periods.
Check it out for yourself! For example, if you buy $100 worth of a stock at $9.00, and $100 at $10.00, and $100 at $11.00 the average price of the stock during these three times was $10 but you only paid $9.93.
Dollar cost averaging is a tool an investor can use to build savings and wealth over a long period. It is also a way for an investor to make the most of short-term volatility in the broader equity market. Dollar cost averaging can be used in retirement accounts. Regular purchases are made regardless of the price of any particular equity within the account.
Note: Fractional shares coming to All Of Us soon.
Dollar Cost Averaging And Investing In The Stock Market Over Long Periods
Investing in the stock market over long periods of time can be a powerful savings strategy. There is some debate around the optimal time period to compare against when calculating average historical returns. Furthermore, it is really the return over and above inflation that matters. If you earn just the rate of inflation you are left with pretty much the same buying power as you had when you started.
Example: $1 Monthly For 30 Years At 7%
Let’s use 7% as the average expected annual return of the overall stock market over and above inflation based on a couple of centuries of historic data. And let’s assume it takes a person a little time to get to a point in their career where they can start saving. Let’s use 35 years of age as a starting point and 65 years of age as an ending point for their dollar cost averaging savings plan.
It turns out that for every $1 invested each and every month for 30 years, if the market returns a steady 7% per year you will wind up with $1,177.06 in savings.
Starting Later Means Less Compounding
You may say “sure” but what about if I start later? Well, over 20 years you wind up with $511.41 and over 10 years you wind up with $151.98. So it’s always significant even though you can see the power of compounding over longer periods.
And note that we are talking about after-inflation dollars, meaning if inflation stays above zero you will have earned more dollars but we are adjusting down for those dollars being worth less in terms of what they can buy.
Now many analyses in finance tend to have assumptions which may not hold. What could go wrong here?
Up Early: Well, if the stock market went way up right at the start of your savings period and stayed there until near the end of your savings period, then dropped a lot you could wind up losing money.
Up Late: On the other hand, if it stayed steady right until the end then jumped up to the equivalent of 7% per year you’d make way more than we projected.
Over long periods, at least over the past couple of hundred years, the market has tended to go up, which may or may not happen in the next couple of hundred years, especially if we get hit by a comet or the ice caps melt and we all have to live in floating homes.
Riding Highs And Lows With Dollar Cost Averaging
Also, the market does not tend to offer steady returns month after month but is usually much more erratic with some big up months and some big down months. Turns out this is a good thing if you are doing dollar cost averaging.
For example, if instead of our above example you buy $100 worth of a stock at $8.00, and $100 at $10.00, and $100 at $12.00 the average price of the stock during these three more volatile times was $10 but I only paid $9.73.
Since you invested the same amount of dollars but paid an average price that is lower, you wound up with more shares. At any ending price except zero (or negative which isn’t really possible) more shares are worth more money.
Real-World Costs And Revenues
In the real world, you don’t get to buy and hold shares for free. But here there are some very important things to consider.
First of all, with the recent growth in brokers offering free trading your costs are reduced to just crossing the bid-offer spread when you buy (and there are some regulatory fees which are likely to still be there when you sell which are small, and of course capital gains taxes which are likely to still be there when you sell which are not so small).
And you can (sometimes) lend out the stocks that you hold and earn an additional return. Your broker will do this for you and it can also add up over time.
Dollar Cost Averaging And Diversifying Your Investment Portfolio
Diversification reduces risk. The most diversified way to invest your money is to hold broad-based ETFs. These ETFs have annual management fees but they are usually quite small. In fact large diversified ETFs tend to have much smaller annual expenses than mutual funds, and one of the biggest and most diversified is the SPY ETF which has an expense ratio of under 0.1% per year.
Another interesting ETF in this category is the Vanguard S&P500 ETF which has an expense ratio of about a third of the SPY, and of course there are other ones to consider.
Using Retirement Accounts
Wherever possible, it is best to first max out on savings through contributions to your retirement accounts. There are different types of these and they all have some tax advantaged features that will help offset at least some of the effects of those capital gains taxes mentioned above.
Check out the All Of Us retirement accounts if you’re looking to take advantage of those benefits.
In summary, regular dollar cost average investing, into low expense ratio, broadly diversified ETFs that you allow your broker to lend out, over long investing horizons, within tax advantaged retirement accounts can be a powerful savings strategy.
How To Set Up A Dollar Cost Averaging Investment Plan
If you are interested in setting up a dollar cost averaging investment plan, there are a few steps you should take:
Determine how much money you can put towards investing each month.
Select an investment or multiple investments that you will be able to hold for a long amount of time. These should be investments you are willing to make and hold for 5 - 10 years.
Invest the money you set aside every month at regular intervals.
The Benefit Of Dollar Cost Averaging
The main benefit of dollar cost averaging is that your average purchase price is reduced by the up and down price movements in the stock you hold. You can expect to benefit the most if you are willing to hold your investment for a very long time.
People who are looking for a shorter-term investment strategy will want to consider other strategies instead of this one. However, if you are looking to invest regularly and with discipline, hold your investment for a long-time, and watch it grow, dollar cost averaging could be for you!
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Dollar cost averaging does not ensure a profit or protect against loss in declining markets. It involves continuous investing regardless of fluctuating price levels. Investors should consider their ability to continue investing through periods of fluctuating market conditions.
The investing information provided on this page is for educational purposes only.