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The Incredible Power Of Dollar Cost Averaging Your Portfolio

The Incredible Power Of Dollar Cost Averaging Your Portfolio

Did you know that there is one very simple way to invest in your portfolio and you don’t need to worry about timing the market? This one easy trick can help you to potentially lower your cost basis and increase your overall returns. I’ve had many conversations with friends and family that never understood what the trick was and here we are going to talk about it in depth. What I am talking about is Dollar Cost Averaging and I want to teach you how to benefit from using the concept in your investing life.

What we are going to discuss about Dollar Cost Averaging

  • What It Is
  • How It Works
  • How To Implement It
  • Does It Work
  • The Downside
  • Getting Started

There is a lot to discuss in this article. I wish I had a cool little gadget that could take me back in time to my younger years and implement this when I first started investing. Unfortunately that isn’t possible so instead I will hope that this information is something you can use as a take-away and make it part of your own personal finance routine. You will see that throughout the various personal finance articles we have written so far, this is actually an integral part of our investment strategy, and today you will learn why!

What Dollar Cost Averaging Is

When you Dollar Cost Average in your portfolio, you are taking the emotion out of your investment strategy. There are two typical reasons that you will Dollar Cost Average. You have a large lump sum that you want to invest upfront or have a smaller amount you wish to contribute month over month. Essentially, what you are doing is figuring out what you want to invest in and then buying in over a period of time.

Lump-Sum

If you have $100,000 to invest, you will buy into the market over 12 months. That means you would put around $92,000 into a cash account that you would draw from, earning a small amount of interest. $8,333 would immediately go into the market on day one, and then each month, an additional $8,333 would go into the market. This typically happens around 30 days from the date you established the DCA, but you can set what day you would like it to pull.

What this does is it allows you to take advantage of short-term market volatility. If the stock drops in the short term, it will enable you to purchase more shares. If the stock rises, you are buying fewer shares, but you get to capture the previous shares’ upside. We will give an example of this later in the article for you to take a look at.

Monthly Contributions

You don’t need a lot of money set aside to take advantage of dollar cost averaging. If instead you invest $100 a month into an IRA or you start making monthly contributions to your 401k, then you are taking advantage of dollar cost averaging. This usually starts by having you establish an automatic, monthly contribution. If you decided to do the $100 a month into the automated strategy, then you would buy $100 worth of shares each and every month on the same day.

This does two things for you. It automates your investment strategy so that you no longer have to think about investing money. This helps with the emotional pull we get each time we put money towards our future. We already do this when we invest in a 401k, and it works the same way if you invest in a Traditional IRA or a Roth IRA. You can also use this strategy for a non-qualified brokerage account or any other investment you would like to be involved in.

How Does Dollar Cost Averaging Work?

When you take the original $100,000 investment and break it down into $8,333 in monthly contributions, you would buy the stock at whatever the share price is at that time. For example, if the stock is at $100, you would purchase 83 total shares. If it drops to $80, you now buy $8,333 worth of shares at $80 or 104 total shares. If the price jumps to $120, that same $8,333 will purchase only 69 total shares for the month.

Let’s compare an investment of $100,000 at $100 a share to a Dollar Cost Averaging example.

Lump Sum Investment Strategy

Total Investable AssetsPrice Per ShareNumber of Shares Purchased
$100,000$100100

As you can see here, we start with $1,000 shares if we invest all assets upfront.

Dollar Cost Averaging Example

MonthShare PriceShares Purchased
1$10083
2$11076
3$80104
4$9093
5$12069
6$70119
7$60139
8$9093
9$80104
10$70119
11$9093
12$10083
Average Share Price$88.301,175 Total Shares

In this example, even though we have had prices both above and below our target price and we end up at the same $100 per share, we now have 1,175 total shares. This is a 17% increase in value over the lump sum investment. Also, you can see here that our new break-even point for our Dollar Cost Averaged investment is now $83.33 per share.

How To Implement Dollar Cost Averaging

The beauty of dollar cost averaging is that you are likely already making use of it and you didn’t even know it. Suppose you have a 401k, 403b, Simple IRA, or SEP-IRA that you contribute to. In that case, you are already making use of the dollar cost averaging philosophy.

The power of automation is your friend. It really helps to take the emotion out of when to buy your investments. I have friends every day that message me about stocks and crypto that they’re going to purchase, and then they see a price drop, so they decide to wait. Next thing they know the price is up above what they were going to initially purchase the investment.

When you let your emotions dictate your actions, you’ve already lost. Our emotions can keep us from achieving financial success because fear is a great detractor.

“If you cannot control your emotions, you cannot control your money”Warren Buffett

You can set up an automatic investment strategy with any Broker-Dealer of your choosing. Inside of a brokerage firm of choice you can purchase stocks, bonds, mutual funds, index funds, or ETFs. If you’re investing in broad-based index funds, as we talked about here, you can really just set it, forget it, and let it do its thing.

Does Dollar Cost Averaging Really Work?

There are three types of markets that we usually see. We have falling markets, we have flat markets, and we have rising markets. Dollar Cost Averaging works in both falling markets and flat markets, but you can get left behind in a rising market.

Let me talk about the three types of markets.

A Falling Market

In a falling market, we typically call this a recession. The market compresses, and for many individual investors, they see the values in their 401k’s and IRAs drop dramatically. What many don’t understand is that this is actually good for you as an investor. So long as you have a job and continue to make contributions to your 401k and IRAs, you are actively purchasing more shares for the same dollars you had before.

This is a tremendous benefit in the long run. Because when the markets eventually rebound to their former highs, you will see that your portfolio is now worth significantly more than when it had initially fallen! One thing is for sure, the markets always rebound to new highs, and it always goes up in the long run. You only lose if you sell.

A Flat Market

This is not something that happens often. We witnessed this once, and it lasted over 10 years. It became known as the lost decade, which you can read more about it at Investopedia. If you want to find any success in a scenario like this, you need to dollar cost average.

Suppose you want to be successful in a flat market. In that case, you need to make sure you are taking advantage of market volatility. You will be able to buy on average more shares by buying at a lower average share price, as we witnessed in the example above. With fluctuating prices, you might find yourself ahead by hundreds or thousands of shares. This is different from a lump sum investment that is only breaking even or ending up with a small loss over that same timeframe.

So, Dollar Cost Averaging can benefit you in this type of market as well.

A Rising Market

Dollar cost averaging can burn you in a rising market. This really only matters if you have a large lump sum versus years of investing left to do. If the market continues to go up for 12 straight months, you end up buying fewer and fewer shares. In the end, you have far fewer shares than you would have had if you invested it all in a lump sum.

A rising market impacts a lump-sum investor the most. The reason is that you are investing over 12 months, and the number of shares you purchase becomes fewer and fewer each passing month. As a long-term investor, you will face several rising, falling, and flat markets over the next 10, 20, or even 40 years of your investing life. These fluctuations will help you build wealth and grow your portfolio over time.

The key here is not to stress out over it. The best thing you can do is continue to invest over time and not try to time the markets.

The Downside to Dollar Cost Averaging

The most significant risk you face with Dollar Cost Averaging is if you enter into it during a rising market, you will buy fewer shares overall. What that means is you’ll still profit, but it won’t be as great of a return as you could have achieved if you had invested all upfront.

This is off-set by the fact that you are automating your investment strategy. That means you don’t have to think about it. You set it up and forget about it. This removes a lot of stress from your shoulders emotionally since you don’t have to find the perfect time to buy whatever investments you’re looking at.

How To Get Started

The process is pretty straightforward if you’re ready to get started with dollar cost averaging inside of your portfolio. If you have a 401k at work that offers a contribution match, that is the place to start. Not only is it simple to set up, but you are also getting free money from your company to invest.

If you don’t have a match with your company, you may want to look at setting up a traditional IRA or Roth IRA if you qualify to invest in them. If you want to find out more about those, look at this article on IRAs we’ve written about before.

There is one last thing we will discuss. You can set up an automatic deposit into a brokerage account that has a purchase plan in place. You can set up an automatic investment plant with nearly all broker-dealers. I recommend one of the four broker-dealers we discuss in that article. These are Vanguard, Fidelity, TD Ameritrade, and Charles Schwab.

Once you have these accounts set up, you’re ready to go. You now have a plan to tackle your financial success and make use of Dollar Cost Averaging. Are you ready to get after it?

Final Thoughts

So we went through a multitude of different things today. Specifically, we talked about what Dollar Cost Averaging is, making systematic purchases over time. This helps you to take advantage of short-term market volatility.

We talked about how Dollar Cost Averaging works and gave two examples. One example is of a Lump Sum Investment and the other using the Dollar Cost Averaging methodology on a longer-term investment strategy. This showed that we could have significantly more shares of our investment for the same cost, which means that our average price per share decreased.

We talked about the three types of markets you’ll face when you invest and how they are impacted by Dollar Cost Averaging. We discussed the differences between a falling market, a flat market, and a rising market. Each has its benefits over the long term.

The downside of Dollar Cost Averaging was discussed next. There aren’t many downsides. A rising market is the worst thing that can happen for your assets under this method. You won’t have the same level of profit you could have had if you had invested all upfront. We also discussed how it helps you to take the emotion out of your investment strategy and focus on the long term, which is an advantage.

Just Get Started

Getting started was the last thing that we discussed. Pretty much any broker-dealer can help you get going. I am a huge fan of Vanguard and Fidelity because they focus on low fees index funds and no-cost trades. These two companies are the perfect place to get started as a do-it-yourselfer.

Add Dollar Cost Averaging to your investment strategy and take advantage of it over time. Your life with have much less stress if you do, and your future self will thank you.

Disclaimer: JustMyLittleMess does not provide tax, investment, or financial services and advice. The information is presented without considering the investment objectives, risk tolerance, or financial circumstances of any specific investor. It might not be suitable for all investors. Past performance is not indicative of future results. Investing involves risk, including the possible loss of principal.