Dollar cost averaging (investing like a robot) has received a bad rap in recent years, and for good reason. For those not investing in low or zero transaction cost accounts such as 401K’s, fees can really diminish your returns. This is especially true for those being managed by an adviser who gets a cut every time he executes a trade for you.
Lump-sum investing does have its merits during times of consistent economic growth and/or low volatility periods. However, when the market takes gigantic losses and is highly volatile, as it has been over the past year – or you are investing in zero transaction cost accounts, the merits of dollar cost averaging have returned with a vengeance.
What is Dollar Cost Averaging?
If you’re unfamiliar with the strategy, dollar cost averaging is distributing your investment contributions over time versus large lump sum payments. An example of dollar cost averaging is the process of having a consistent percentage taken out of your paycheck each pay period and having that amount contributed to your 401K. The same kind of discipline can be used in dividend reinvestment plans (DRIPS), or manually by you with all investment purchases.
How Does Dollar Cost Averaging Perform?
If you had invested lump sum amounts on Jan. 1 of each of the last 8 years vs. spreading that amount out at the beginning of each month, dollar cost averaging would have resulted in better returns in 5 of the 8 years, and absolutely destroyed lump sum investing in 2008.
Why Dollar Cost Averaging is Good for All (Especially Newer) Investors
1. Buy More on the Cheap
If you invest all at once in one lump sum when the times are good, you don’t have any money left for when shares are cheap. Buying cheap means better gains when the market does rebound.
2. Removes Emotion
Dollar cost averaging forces discipline at times when investing doesn’t seem to be the best idea. Study after study shows that once emotion becomes involved in your investing strategies, your results are going to be impacted in a negative way.
3. Helps you Avoid Timing the Market
Adding shares on a strict, regular basis means that you avoid trying to time the market. Day trading is for experts who live and breathe the stock market 12 hours + per day. Even they struggle at times to achieve market beating returns. What are the chances you can beat the pros by clicking ‘buy’ and ‘sell’ on your lunch break a few times per day, week, or month?
4. Distributes Risk
If you were to make large lump sum payments, you can easily get burned buy putting your money in at the wrong time. Think Dow 14,000 in December of 2007 and Dow 8,000 in November 2008. At the same time, you’d have nothing left to buy shares at recent price lows.
5. Lowers Stress
Large investments all at once can result in a great deal of stress in trying to figure out if ‘now is the right time’. The answer is, nobody truly knows. Investing via dollar cost averaging removes the stress of playing the guessing game.
Final Thoughts on Dollar Cost Averaging
Everyone loves to hate the concept of dollar cost averaging (it’s not quite as dramatic or fun, after all). However, straying far from this strategy can lead to disastrous results in volatile times.
Dollar Cost Average Discussion:
- Do you dollar cost average?
- Why or why not?