How I learned this valuable technique
Last year a lot was written about dollar cost averaging, an old school investment strategy. What I have found is that many investors don’t really understand what it means. So I thought I’d provide an overview in our series on investment basics. I’m also going to share how I learned this valuable technique early on.
What is it?
Dollar cost averaging (DCA) is buying a fixed amount of an investment at regular intervals regardless of price. You can think of it like investing on auto-pilot.
How does it work?
It works much like the process of investing in your 401k. You invest a set sum of money in a specific investment at regularly scheduled intervals ignoring what may or may not be happening in the market. This assumes that you will be buying more shares when the price is lower and that over time your average share price is reduced. This is also very similar to the way a Dividend Reinvestment Plan (DRIP) works. In a drip plan an investor holds a position in an investment and then reinvests any dividend payments into additional shares, dripping more money in over time.
Is it right for you?
As is true for most things… That Depends!
Earlier I said a lot was written about this recently. In July 2012 a large financial services firm did a study that received a lot of air play regarding the value of DCA compared to investing a lump sum. The conclusion was that investing a lump sum at one time rather than a little at a time results in a better long-term return. This may be true IF you have a lump sum to invest. That wasn’t my case when I began investing! It isn’t the case for most novice or beginner investors. For them DCA is the only way to go.
DCA makes sense for other reasons. Here’s why. It’s emotional!
You have heard me say that many times. What happens to the Psyche of an investor who has a lump sum and decides to jump in with both feet, only to experience a market correction of 25% the next day, week or month? This action could result in a loss of principal that takes a long time to overcome. This investor may decide irrationally that the market is too risky and cash out, putting it under the mattress for safe keeping. As a result this investor is never going to see the capital growth needed to accomplish their long-term investment goals.
Why is this bad? Knee jerk reactions are rarely productive choices in any area of life. Proper investing requires a sound strategy and stated objectives for a desired outcome. It isn’t like playing the craps tables in Las Vegas.
Consider the investor who has a lump sum to invest but decides to sit on the sideline waiting for the lowest possible point to jump in. There is no crystal ball! If the market never takes a dip then this investor is sitting on the sidelines not participating in the upside. They may be thinking I’ll wait until tomorrow and then tomorrow never comes. Many people need the forced discipline that DCA provides. It’s human nature, we all need discipline even if we say we don’t want it.
Most investors have built wealth by investing a little at a time over many years. If you are fortunate to have access to a company sponsored retirement plan such as a 401(k) or 403(b) this is exactly how they work. You make a contribution on each pay period and the plan sponsor invests it on your behalf, based on your investment instructions. Over time you have the potential to save a sizable sum of money for retirement. It’s that simple.
It worked for me!
I began investing when I was 24 with a small amount every month. I opened my account with $50 which seemed to me to be quite a sum at that time. I added to it. This was several years before I was involved in the planning industry. What intrigued me at that time – because I knew very little about investments or financial planning – was that my small invested amount received the same attention as a richer person’s bigger amount. There was no discrimination on how the money was invested due to the amount invested. This still holds true today with this type of investment vehicle. I still think this is way cool! In fact I still own this original investment.
If you do have a lump sum and are considering investing I encourage you to be like Nike and “Just do it” but have a plan. If you are uncomfortable jumping in with both feet or have a large sum consider a modified DCA strategy. Split your lump sum into 3 or 4 equal amounts and set up a standing order to invest each portion on a specific date of the month or day of the week. Don’t try and time the market, have a plan and stick to it.
Just do it! You’ll be glad you did!
Investing involves risk including the potential loss of principal. No investment strategy can guarantee a profit or protect against loss in periods of declining values. Past performance is no guarantee of future results. Please note that individual situations can vary. Therefore, the information presented here should only be relied upon when coordinated with individual professional advice.