Dollar cost averaging: an excellent strategy for the investor with money to deploy, but worried about the risk of going into the market all at once. With that in mind, this article will try to set your mind at ease and explain how dollar cost averaging might just be the psychological trick you need to get your money working for you in stocks!
Hit Me With a Quick Dollar Cost Averaging Factoid
Let's say you first entered the workforce in 1988. Let's also say that on every 15th of the month since you started working, you invested $500 a month into an S&P 500 Index Fund. You never sold any of your fund.
That's 308 purchases, equaling about 26 years in the workforce, making you right around 50 years old.
308 purchases, $500 at a time - that's $154,000 invested in the stock market.
Well, how much do you think your purchases would have been worth on February 7, 2014? $200,000? $300,000?
DCA, An Example!
That behavior, of course, lent the name to this article. 'Dollar Cost Averaging' is the process of automating your investments by just sticking to your investment plans over a long period of time, and buying on a schedule. Often this can be once a month, or perhaps, once a paycheck.
Inspired by an interesting question on the Bogleheads forum, (which sent a fair amount of traffic to our S&P 500 reinvestment calculator) we set out to quickly answer poster sls239's question about market timing while investing monthly... and teaching an important lesson about Dollar Cost Averaging and Overanalysis. And... ulcers.
We, of course, tacked on a few assumptions - namely, this mystical S&P 500 mutual fund had no fees, no taxes owed, reinvested dividends for free, and our investors never sold. So, we ran three scenarios corresponding to the questions in the forum, using the S&P 500 Total Return Index:
- Investor A: A didn't try to time the stock market at all. He only purchased shares on the 15th of the month (or the next day in which the market was open).
- Investor B: B attempted to time his purchases, but did a horrible job at it. So bad, in fact, that he bought the market every month at its peak - as in, on the market's peak.
- Investor C: C attempted to time the market, and was incredibly adept at it. He managed to perfectly time every monthly purchase, buying that month's minimum.
Investor C must have destroyed the other two, right? Wrong again!
Here's how our heroes performed:
|Investor A||Invest B||Investor C|
|(Steady)||(Bad Luck)||(Brilliant Timer)|
|Average Yearly Return||8.745%||8.595%||8.923%|
Shockingly, the difference between perfectly timing the S&P 500 every single month through 26 years of a career and the bad luck version of that strategy was a mere $29,068.26 cents. Investor C's edge was a miniscule .33% over Investor B. Here's a graph showing Investor A's (our steady hero's) account value over time:
Why Bother Overoptimizing?
Seriously now, what's the point? While you expected to see results similar to the famous traffic jam scene in the beginning of Office Space, it turns out that when investing in a large diversified index fund over a long period of time, your timing barely matters at all.
As a matter of fact, Investor A comes out way on top in this scenario - without spending any time attempting to calculate fair values or using technical analysis to nail his entry points in his month to month investing, he merely took his paycheck and bought his $500 of S&P 500 in the middle of the month without fail. While his over-optimizing friends B and C wasted precious heartbeats on a pointless problem, Investor A showed us what comparative advantage means... and became B and C's boss.
Seriously... Just Invest... Early and Often!
Your takeaway? That's a simple one. If you're like the majority of Americans (or Canadians, or Russians, or <insert your country's people>), you get your paycheck from a steady job. When you get your paycheck, you should invest said paycheck in a broad mutual fund (perhaps even in the S&P 500? Your call!).
Worrying about perfectly timing every paycheck is going to eat into your time which can be better spent elsewhere - like, say, in climbing the career ladder or starting your own business. Suffering and stuttering over every purchasing decision is just going to give you an ulcer.
Seriously - your call. Do you want ulcers from straining your brain every trading day for 26 years in a row, or can you live with an iron stomach and without $15,784.13?
Yes, you're welcome - you can thank me for your good health in 26 years. And, yes, I'm glad to settle this question.