Dollar Cost Averaging Strategy

There is this cool thing that happens when you ignore all the stock picking stuff that people talk about, stop paying attention to the “experts” on TV and simply invest your money in a dispassionate and consistent manner. The aforementioned “cool thing” is that you end up with a lot more money. Now I know people have told you to “buy low and sell high” and maybe you’ve even read a few investing books, but the fact is that the vast majority of people are terrible at timing the market. The media plays a huge part in this because they offer so much noise (both literally and figuratively) and that can’t help but distort markets. Think about how media makes money – they need to sell advertising, and to do that they need viewers. Is the best way to gain viewers to merely report market events and maybe do some journalistic digging? Unfortunately it is not. The best way to gain viewers is to be as sensationalistic as possible. This is why when you watch investing shows everyone is either predicting a massive downfall or a new bull market and everyone appears to know exactly what to do. The facts simply do not bear out that these experts know what they’re doing.

Related: ETF Investing – Low Maintenance and Stellar Return

Everyone Seems to Beat The Market… So Why Is It Still There Again?

Almost every investing study out there says that the average investor would be much better off if they kept their investment methods simple and consistent. One of the main reasons for this is the natural rewards of dollar cost averaging investment strategies. The idea is to automatically take a percentage of your earnings each period (I set mine up for quarterly, but as long as it is consistent almost any period will do), and invest in as a diversified manner as possible. The exact amount of risk you want to take, and your long-term balance you want to have between different asset classes is something you can decide on in under an hour with the help of a fee-only financial advisor, or by reading some basic investment blogs. If you take a consistent percentage of your earnings throughout the year, and invest it according to you pre-approved plan, your chances of success go much higher.

Related: Investing Series – Asset Classes

Now I can hear some of you hollering out there that it is crazy to buy when the market is high, why would you want to buy more then? The fact is that no one has any idea when the market is high or not. At various points in the last couple decades people thought that equities were done their bull run only to see them rise by 30% over the next couple of years. The same phenomenon of misinformation and hesitation occurs when the market is sinking as well. Who wants to invest when they impression is that their investment will likely be worth less the very next day? The investing gurus out there even have a catchphrase for it, they say, “Never try to catch a falling knife.” Absolutely ridiculous, but hey they are doing so well handling their own investments these days that their Golden Boy (Jamie Dimon) only lost a few billion dollars (and he isn’t even sure how) so I’m willing to read from their gospel. The bottom line is that by taking the emotions out of the game, and merely sticking to a basic plan, you will do far better than most.

Here is the math behind what I mean. The downside of dollar cost averaging is that you will definitely buy into markets when they are at their high points. The nice part is that equities and other asset classes have basically only went up over extended periods of time, however it often takes decades for those larger economic cycles to truly reveal themselves. On the flip side of the equation, you will also always buy when the market is at its lowest as well. Now some of you might be saying, “Ok, so I’m going to get average returns then because they highs and lows will cancel out, why is this so great?”  This is where the “genius” of dollar cost averaging strategies comes into play. Take a look at this example (the term units is just an arbitrary form of measurement):

Dollar Cost Averaging Case Study

You’re able to regularly save $200 per month.

  • In January, the units cost $1 each, so you’re able to buy 200 units.
  • In February, the cost of the units falls to $0.95, so you’re able to buy 210 units.
  • In March, the cost of the units again falls, this time to 85c, so you’re able to buy 235 units.
  • In April, the cost of the units rises to $1.05, so you’re able to buy 190 units.
  • In May, the cost of units rises again to $1.15, so you’re able to buy 174 units.

Now, the average price of the units on a monthly basis was $1, and you bought 5 months’ worth, so you likely have around $1000 worth of units that cost $1 each right? Let’s see:

At the end of May, you own 1009 units. Your total cost over the 5 months was $1000, which means that the average price of the units you bought is actually $0.99. In other words, you made more money than if you merely had purchased 1000 shares at the average monthly price. This is due to the fact that you naturally bought more when the market was low.

As you can see, when prices rise you will naturally buy less of your specific asset class (at this point my life, it’s almost always equities for me). When prices are low, your consistent amount of money will purchase more shares for you. In this manner you are guaranteed to buy more when the market is low and slant the market toward yourself a little bit. It will only make a slight difference in terms of percentages, but over time, the compounding effect can make a huge difference.

Related: The Magic of Compound Interest

I honestly believe that unless you have access to some of the top hedge fund managers out there (these guys do exist… if you have net worth of over $1 million), the most efficient and stable way to accrue investment returns is to use dollar cost averaging through a discount brokerage and basic ETFs. Using this method, you will eliminate a ton of fees over the long haul, you will diversify your hard-earned capital, and you will take a lot of the emotion out of your investing (which is exactly what kills most investors’ overall returns). Set a plan for asset allocation, open a discount brokerage account, hook it up to your bank, automate your finances, and worry about more important stuff in life!

 

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Dollar cost averaging is a great tool and is exactly how I invest. I know I can’t time the markets as much as I would like to and have a long time horizon so I’m willing to ride the proverbial roller coaster.

Thanks for this! In todays time the magic of compound interest is to be understood which in turn leads to dollar cost averaging and therefore exact way to invest.

I agree! It is my investment strategy too.

Once I have regular income I plan to use dollar cost averaging. Right now I just invest when I have money and when I think the price is good enough. I also want to try value averaging where you invest so that the total value of portfolio increases by a certain amount each time period. So you buy more when your investments are down and possibly even sell if they are up too much, taking a bit of profit during bull markets. I want to try this method but without the selling, as this would only increase the returns. I… Read more »

It makes sense that value averaging would work better because you get to choose your returns, but the problem is to do it some months you would need a lot more cash than you have to meet your goal. I pick individual stocks now. I have a long list of companies I look at when I have the money to invest, and if I can’t choose or if the entire market is down enough I go with the total TSX ETF. I don’t try to beat the market or anything, I just try to have my returns be as high… Read more »

Hi there,

In the nut shell it is very clear and concise article. The examples are great. I have evidence as well,
that low risk and cost effective to save for a rainy day is ETF and diversification. However one have to ready and patient – if you do not save away more than 20% of your paycheck you will be lucky to achieve independent retirement by the time you are 65 ; -)

I get that the big guys skew the market a bit. I try to pick stocks that I will never sell, so my return is simply the dividend (working to FI). So I am not subject to heavy trade commissions upon selling nor selling at the wrong time. I work kind of a dollar cost averaging strategy but it is not as regular as someone with regular income. I find investing and moving closer to financial independence fascinating enough that I consider the money I use to buy stocks and ETFs as both saved money and my entertainment budget. This… Read more »

Go Yankees

Dollar Cost Averaging is a good strategy, but the problem is we are all human and we have emotion. Sometimes you may not follow the strategy especially when the price is going down because you doubt if the price comes back and make profit even you actually know that consistently following the strategy is likely to make more money. I am that kind of person. I need someone else to manage my money. So, I got financial advisors and left all the tasks to professionals. Some are good, some were not so good. It takes a while to find a… Read more »

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