Over the past weeks, I have been thinking about how to best make use of this economic downturn. I came across the concept of dollar cost averaging. Now, you may have heard about this strategy before and asked yourself: how can dollar cost averaging protect your investments? Well, I went into my research cave for a while and this it what I found:
How can dollar cost averaging protect your investments? Dollar cost averaging can protect your investments by reducing risk and at the same time increasing returns. Furthermore, dollar cost averaging makes it easier to diversify your portfolio as your spreading out your stock purchases over time.
What is dollar cost averaging?
But – in order to better understand how this investment model can actually protect your investments – let’s first have a look at what dollar cost averaging actually is!
Dollar cost averaging is a simple investment strategy in which the investor splits up his entire available capital to be invested into little chunks of cash that can be invested over time. For instance, say you have $12,000 available to invest in the stock market: instead of putting that lump sum in the market at once you split it into 12 chunks of $1,000. Over the following 12 month you would then invest $1,000 (ideally into an ETF of your choosing).
But why go through all this trouble?
Well, dollar cost averaging is used foremost to mitigate the impact of market and price volatility. As stock market prices fluctuate over cycles in time the actual price you are paying for a stock does not necessarily reflect the stock’s (or the company’s) actual underlying value. By spreading out your investments over time you will even out the price action and will end up paying on average about what the company is actually worth.
How do you invest with dollar cost averaging?
Let’s get back to the example above and imagine you had $12,000 available to invest at the beginning of 2019. Now, you heard about dollar cost averaging because of your unquenchable thirst for financial knowledge and independence (an you have read this blog post), so you decided to do dollar cost averaging.
This is what your schedule and portfolio would have looked like:
|Date||Amount Invested||Current Portfolio Value||S&P 500 Index Value|
|2019.01||$ –||$ –||2607.39|
|2019.02||$ 1,000.00||$ 1,000.00||2754.86|
|2019.03||$ 1,000.00||$ 2,019.12||2803.98|
|2019.04||$ 1,000.00||$ 3,093.58||2903.8|
|2019.05||$ 1,000.00||$ 4,045.13||2854.71|
|2019.06||$ 1,000.00||$ 5,100.53||2890.17|
|2019.07||$ 1,000.00||$ 6,293.93||2996.11|
|2019.08||$ 1,000.00||$ 7,094.53||2897.5|
|2019.09||$ 1,000.00||$ 8,310.89||2982.16|
|2019.1||$ 1,000.00||$ 9,297.44||2977.68|
|2019.11||$ 1,000.00||$ 10,693.54||3104.9|
|2019.12||$ 1,000.00||$ 11,939.72||3176.75|
|2020.01||$ 1,000.00||$ 13,319.58||3278.2|
I generated this table with a very handy dollar cost averaging calculator I found here.
Now, this table tells us a lot things. First and foremost, that 2019 was not a great year for investors in the stock market. But besides that, as the S&P 500 Index Value fluctuates over time, your investments remain constant.
This example of dollar cost averaging is quite simplified but I think it gets the point across well. Of course, there are many other factors to consider when dollar cost averaging: how far should you spread out your investments? What do you do with the money that you are holding back?
The answer usually is: it depends. If you have a stable monthly income which will in all likelihood will continue after the 12 months it can make sense to adjust your monthly investments accordingly. Say you have a lump sum of $12,000 to invest but also can save another $500 each month which you want to invest. In this case you may want to think about stretching those $12,000 out longer over 2 or 3 years to have a consistent fixed sum of money to invest.
If you’re a pro you might also think about adjusting those fixed investment chunks to inflation.
How does dollar cost averaging reduce risk?
Up until now we have looked at what dollar cost averaging is and how you can make use of it in your investment strategy. I have told you that it can protect your investments by reducing overall risk. But how exactly does dollar cost averaging actually reduce risk?
Let’s say the price of any good ETF is $50 in January. $1,000 then buys you 20 shares. If in February the price drops to $25, $1,000 would get you 40 shares. If it increased to $75, you get 10 shares.
What I’m trying to highlight with this clumsy example is that dollar cost averaging has the effect of you buying up more shares when prices drop and buying less shares when prices rise: A very “natural” way of balancing risk and protecting your investments from volatility.
When prices are high and stocks tend to be overvalued dollar cost averaging reduces your risk by getting you less shares at high prices. When prices are low and stocks are a good buy your $1,000 investment will get your more shares at low prices. How great is that? And you don’t even have to think about it!
If we visualize the above table we see how steady the increase in your portfolio actually is value is with dollar cost averaging: steady growth, reduced volatility.
What is the advantage of dollar cost averaging?
The big advantage of dollar cost averaging becomes even more apparent when compared to other investing strategies such as buying a fixed number of shares each month or just investing whenever you feel like it (don’t do this!).
These are just some of the advantages I want to highlight here:
1. Risk Reduction
As we have seen above dollar cost averaging reduces the impact of market volatility and smooths the overall ride of your stock portfolio. In addition to this, it might also reduce your own fear of “choosing the wrong moment” when investing larger sums of money.
Following the dollar cost averaging strategy and having a fixed amount to invest each month keeps you accountable and acts as a monthly reminder of your investment goals, whatever they may be.
For me, dollar cost averaging has made a huge impact on my focus and mindset when it comes to my monthly savings rate. Having that fixed number in mind I want to hit each month is an attainable goal I can focus on.
3. Reduces Emotional Involvement
Having a solid plan in place of how and when to invest may reduce the risk of investors “following their gut” or making investment decisions based on emotional reasoning. Let’s face it, we are instinctive and emotional beings and while these qualities make for great societies and civilizations they are not beneficial in the world of investing.
Implementing this simple strategy will help you invest the same amount every month like a mindless, emotionless zombie. Perfect!
Does dollar cost averaging really work?
Now that we have discovered all these benefits to dollar cost average the important question of course remains: does dollar cost averaging actually work?
Any by that I mean, does it accomplish what is sets out to: reducing volatility for the average investor.
Remember how we saw the smooth portfolio growth in 2019 in the graph above. Well, let’s compare that to a lump sum investment of $12,000 at the start of 2019:
The difference here is quite obvious. Does dollar cost averaging reduce volatility: yes!
And that is what dollar cost averaging is all about.
Let me know what you think! Are you considering dollar cost averaging? Is the volatility reduction worth potential missing out on bull markets?