Expecting your year end bonus soon? Do you invest it all at once? Or try to capture the benefits of dollar cost averaging?
What is Dollar Cost Averaging?
Dollar cost averaging (DCA) refers to buying a piece of the investment consistently, over time. In this way, the same investment dollars, say $100 / month, will buy you the investment at the average price of that investment. When the price is higher, your $100 doesn’t buy as much, whereas when the price is lower, your $100 buys more. This averages the cost of ownership out, and mitigates the chances of you buying at the market peak.
This sounds good in theory, and I must admit, I am a big advocate of this idea.
If you buy into the idea that dollar cost averaging works, then you will consistently buy into the market without worrying about what the price is at that current moment. That’s because, in the long run, you’ll average your cost of ownership out.
I recommend automating your investments, so that on a preset schedule, those investments are purchased into your portfolio. This automation removes your emotions from the equation, and eliminates the gambling aspect of investing where you try to time the market. You no longer need to concern yourself with whether tomorrow's prices will be higher or lower than today's.
If this philosophy works so well, why then would I argue against Dollar Cost Averaging when you come into a large windfall, like a bonus, commission cheque, or inheritance?
“Stonks always go up.” - /r/WSB Reddit User
A phrase coined by the popular investing subreddit sums up precisely why Dollar Cost Averaging doesn’t work in the long run. Stocks always go up.
This of course is not true in the short term. But the objective of long-term investing isn’t to gamble on the short term outcomes, but to make a sure bet on the progressive growth of companies over the long term.
We’ve seen the truth in this statement time and time again. At the time of writing in February 2021, the NYSE and Nasdaq are sitting at all time highs. Not even 12 months after the coronavirus plunge on March 23rd, 2020. Those highs seen today are far above the 2008 highs just before the market-altering financial crisis and subsequent stock market crash.
Is today the day before the next crash?
Depending on which television station or professional economist you tune into, you’ll hear all sorts of claims. Tomorrow could be the end of the world, or it could be the day that financial markets soar ever higher. The truth is, nobody knows. Anyone who says they do know is simply making a prediction, a guess no different than who will win the next sporting event or reality tv show. The bolder the prediction? The higher the TV ratings. Those so-called experts are just clamoring for attention over all the other noise in our lives.
Listening to any of these programs is sure to play on your emotions. What if they know something I don’t? They are the experts afterall. Am I being played for a sucker? Why does the other expert say something different? Who is right? Can I still win this game?
The cost of these emotions is all too often inaction.
That is why, when you come into a large extra payment, it’s best to jump in with both feet. You can’t predict the future in the short term any better than these television “experts”. And you know, in the long run, stocks always go up.
Let’s look at this in a real example. Assume in 2008 you came into $10,000 to invest. Also assume you’re the unluckiest person around with investing. In 2008, the S&P 500 hit it’s high for the year in August, hovering around $ 1,300. The following 6 months saw a progressive decline all the way to $676 in March 2009.
If you had invested all $ 10,000 in the markets in during the August 2008 highs, and left those investments alone throughout the following market meltdown and subsequent revival, today you would have tripled your investment, owning $ 30,267.92 (calculated at market close, Feb 12th, 2021). That’s a 300% return in 12 years! Not too shabby for the unluckiest investor alive.
To make that grow even further, you could have averaged down through dollar cost averaging throughout the following 6+ months of market decline and market recovery. Turning that 300% ROI into something even higher.
If on the other hand you had tried to time the market, when would you have invested those dollars? March 9th, 2009? Unlikely. That’s the absolute bottom, and investors had just had their confidence shaken. 40% losses in 6 months, a staggering number. What about the end of April 2009? Well by that time the market had already recovered 29.13%. Waiting any longer than that and your returns were even less.
You see, there’s no better time to invest for the long term than today. We don’t know what tomorrow will bring, and barring a world-ending event, it’s quite possible that today’s prices are the lowest we’ll ever see again.
Stonks always go up.
The Market Vs Stocks
One caveat is that we are looking at the market performance. Taking a gamble on any one company is exactly that, a gamble. The market, on the other hand, is a collection of all companies. Sure, some companies fail. But those companies that fail are replaced by other companies. Some do exceptionally well. Some don’t.
The fact is, the best players in this game are constantly changing.
General Motors dominated the market for years, before needing a government bail out. Meanwhile Tesla came in out of nowhere and captured large swaths of the market.
But one thing is for sure. This game will always be played.
When you come into extra money, make the guaranteed bet, that the market will continue to increase in value. With this knowledge, you will be sure to buy at today’s prices. 3 to 5 years from now, you’ll only wish you could get those investments at the prices you did just a few short years ago.
If those same investments ever do go on sale in the future, load up on some more. This will average down your cost of ownership, and make your returns just that much higher.