Even the phrase “dollar cost averaging” should put most people to sleep. Yet, here it is.
Dollar cost averaging is an investing “strategy” that basically says, if you invest the same amount regularly over time, sometimes you buy high and other times lower. Because you’re investing the same amount of money each time, when prices are lower you buy more shares. The way averages work, that means your average purchase price is weighed down (which is the right direction) because you buy more shares at the lower prices than you do at the higher prices.
That’s a mouthful (or paragraph-ful as it is).
I came across an article on Money Badger (a site you should follow, as it has good educational materials) about dollar cost averaging with a video explainer that’s useful.
There’s always a ‘however’, isn’t there? (It’s because I ask good questions.)
However, I disagree with the example they use. Or rather, I don’t think there example is the most relevant.
Let’s say you have $12,000 and want to invest
And go on to tell you to invest $1,000 per month instead of investing all at once in order to capture the benefit of dollar cost averaging.
If you were to invest in a dividend paying stock, you’re missing out on a couple of percentage points of return by waiting (because you’re not getting all the dividends on the uninvested amount). And, you lose the power of a year of reinvestments and dividend growth (so, your paycheck growth over the course of the year could be about 10% if you invested all at once), if that’s what you choose (and you probably should). So, I’m not convinced that if you have a lump sum to invest, the best thing to do is spread that investment out over a year. Not to mention that many people would probably spend that money over time if it’s accessible in a simple savings account waiting to be invested.
Creating healthy wealth-building habits
Where dollar cost averaging is really helpful is when trying to create an investing habit.
Habit formation is an interesting topic as it relates to investing. I talk about it in my book because it’s important to create a successful habit formation loop in order to develop a discipline around investing. And, you’re not going to create a new habit if the habit is not rewarded (and it’s not rewarded if each time you invest you feel like you’re losing).
In any case, the ideas of measuring paycheck and raise are the positive reinforcement you need to develop a good habit.
Dollar cost averaging comes in as another way to reinforce the habit. If you setup an automatic monthly investment, dollar cost averaging helps you understand why you don’t care about the exact purchase price because over time you benefit by a lower average cost of purchase.
Said differently, you might face two choices — buy $50/month automatically, or put aside $50/month and buy when you think the price is “good”. Putting aside that you’d never really know what that good price is… and the fact that a small price change over a $50 investment really isn’t much… if you buy regularly and automatically, you’ll benefit emotionally with fewer decisions to make, and you’ll benefit financially with dollar cost averaging lowering your average cost over time.
Building healthy financial habits is hard, just like losing weight or any other long-term habit that’s trying to change a conditioned behavior. Every little bit helps and that’s why if you can get your head around dollar cost averaging, it’s worth watching the video on Money Badger.
And, if you’ve read this far and want another well written article, have a look at this article about Dollar Cost Averaging on Modest Money.
If you’re looking to get started developing a personal financial wellness plan, have a look at my free email course Money Making Money.