Dollar cost averaging is, simply, investing a set amount of money at regular intervals. Many people already do this (for example, if you set aside a portion of your paycheck to go into your 401k or IRA, you’re basically already participating in dollar cost averaging). The idea was developed in the 1930s and 1940s, after the Depression, and was primarily meant to help investors avoid taking big hits from a fluctuating market.
The idea was that if you invested all your money at once and the market hit a downturn, you could lose a lot. If you invested over time, you could control (to some extent) how much you lost. Then investors realized that by investing over time, you could also take advantage of lower share prices.
Where does the name ‘dollar cost averaging’ come from?
The ‘cost’ we refer to in the term ‘dollar cost averaging’ is the price of a share or fund. Say you intend to buy into an index fund like SPY, which tracks the S&P 500. The cost (or price) of SPY changes every day, so the cost will likely be different on February 2nd than it was on January 2nd. That means $500 will buy you a different amount of SPY shares each day you go to invest your money. That’s where the averaging comes in.
If you invest the same amount of money at different prices, you can calculate the average price of the shares you bought. The price of SPY fluctuated a little in the first six months of 2018, with an average cost of $267.69.
|Date||SPY Price||Shares Purchased
What does that mean?
You’ve heard the phrase “buy low, sell high”, and this is where it comes into play. April 2 and May 2 were the best days to buy SPY (from this limited data set), but of course, you couldn’t know that was going to be the case when you started investing in January. You managed to buy a total of 11.21 shares of SPY, and with a total investment of $3000, your investment is now worth $3,067.73 (big money, we know).
The price you paid per share is $267.56, a little under the average price of the share over the six months, and cheaper than the price of SPY in four of the months (January, February, March and June). That means four times out of six, if you’d invested your $3000 all at once, you would have done worse than you did buying over time. Way to buy low!
But keep in mind that this is an extremely small sample, and also that the $8 difference between your average cost and the highest cost (from February) is not all that remarkable. If the market is rising regularly, you can miss out on gains by delaying your investments. Dollar cost averaging is not meant to be the most profitable way to invest.
That’s why dollar cost averaging is a great tool for passive investors.
Remember that passive investors aren’t trying to beat the market, simply keep up with it. Missing out on gains here and there is far less important to passive investors than mitigating the risks of the market. When the average price you’ve paid for your investments is lower, you’ve literally risked less in the market.
Additionally, committing to dollar cost averaging can help us avoid the knee-jerk bad decisions common to inexperienced investors. As much as we repeat “buy low, sell high” to ourselves, many investors try to pull out of the market when things look like they’re on the way down, instead of holding out for long term rewards. If you commit to investing a certain amount every month, you’re more likely to buy when prices are low, and potentially reap the benefits if the market turns around (which, historically, it does.)
How can I incorporate dollar cost averaging into my portfolio?
Set up recurring deposits, either through your paycheck, your bank, or your investment platform. Recurring deposits are the pinnacle of the “set it and forget it” mentality of passive investing. So go ahead – set it and forget it.