Dollar Cost Averaging: Take the Emotion Out of Investing

By its very nature, investing can be an emotional experience. After all, you are taking money that you worked hard to earn and save and putting it into an investment that typically has no guaranteed return. As a result, your money could appreciate or depreciate. Granted, thorough research and careful consideration should reduce the stress associated with such situations, but there is an investment method that removes the desire to buy or sell at the wrong time.

Most of us tend to buy or sell at the wrong time. The reason we do this is because that is what the masses are doing. When the stock market is high and keeps going up, the general investing community is excited and continues to pour money into the stock market. In contrast, when there is uncertainty surrounding a major election, international conflict, or global events, there is a tendency to pull money out as the market goes down. While such actions can sometimes be prudent. In the majority of situations, if you have invested in a solid company, you will benefit more from looking beyond the investing consensus and seizing opportunities. The general axiom for investing is “buy low, sell high.” However, as we just examined following the masses tends to result in doing the opposite. Rather than seizing an opportunity to buy an undervalued stock when most investors are panicking about a short-term situation, such as an upcoming election, if you get overly emotional and fall prey to the fear, then you will refrain from increasing your investments or even sell as the market continues to decline, so consider dollar cost averaging to avoid letting your emotions negatively impact your portfolio.

What is dollar cost averaging?

Dollar cost averaging is a relatively simple and easy-to-use investment strategy. As the term implies, you are using an average, but what is being averaged? The average is the price you pay for the stock. Rather than trying to precisely time the market, which even the experts can rarely predict, it is more beneficial to be consistent with your investments and contribute every month. With dollar cost averaging, you will first determine how much you can invest. If that amount is $500 per month, then the next step is to create a recurring investment. This investment will take place on the same day every month. For example purposes, we will assume you choose the 15th day of the month, so on the 15th day of every month. Once you know the amount to be invested and the time of the month you will invest, the final step is to choose the investment. For most, an index fund is a great choice. An index fund, such as the Standard and Poor’s 500 (S&P 500) provides diversification, as your money is spread across 500 companies in numerous industries. As a result, the long-term average performance of this fund has hovered around 10%. Assuming you decide to utilize an S&P 500 index fund, then to get started with your dollar cost averaging strategy, you would simply invest $500 on the 15th of every month into the S&P 500 index fund of your choice. Almost every investment firm has its version of the S&P 500, but the fund performances are extremely similar. If you are interested in choosing a top-tier broker to get started, take a look at our top three picks.

How does dollar cost averaging work?

The basic premise of dollar cost averaging follows the “buy low, sell high” concept. By keeping the dollar amount invested consistent every month, you will buy more shares when the price is low and fewer shares when the price is high. If the stock is $25 per share in January, then your $500 will buy 20 shares. If the stock rises to $30 in February, then your $500 will only buy 16.7 shares. If the price then drops in March to $20, you will buy 25 shares with $500. It is important to note that you did not have to consciously decide how many shares to buy, rather your investment strategy did that for you, which is the beauty of dollar cost averaging. To find out the average cost of your shares over this three-month period, you will divide the total amount invested by the total shares purchased. In this case, you invested $1,500 (3 x $500) and purchased 61.7 shares. Therefore, your average share price is $24.31 ($1,500 divided by 61.7). While this short-term example demonstrates the concept of dollar cost averaging, it is difficult to see the full value because long-term fluctuations can be significantly more fluid. However, even from this example, you can see that by using dollar cost averaging our average share price is lower than the price paid in two out of the three months. $24.31 is less than the January price of $25 and less than the February price of $30. The only way you could have beat this investment strategy is by investing in precisely the right month (March); however, not only would accomplishing this be extremely difficult, but it would also require considerably more effort. You would have to continuously monitor the stock price, keep up to date with larger market trends, and manually purchase the stock at just the right time. In contrast, dollar cost averaging is a fire-and-forget strategy. Once the investment plan is in place, you can focus your efforts on any of the many other priorities fighting for your time. While you should periodically assess your investments and consider adjustments, this process only needs to occur once or twice per year.

What are the benefits of dollar cost averaging?

Automates investing
Takes the emotion out of investing
Avoids the pitfall of buying or selling at the wrong time (being persuaded by the masses)
Requires minimal effort
Grows your investments consistently
Results in a fair purchase price (buying less when the price is high and more when the price is low)

Conclusion

Consistency is the key to investing, and dollar cost averaging is the definition of consistency. It is an investment strategy that anyone can easily establish because it requires an extremely minimal amount of effort. Most of us have busy lives, so it is easy to forget to invest, but the beauty of dollar cost averaging is you do not have to remember. Instead, simply set up a recurring investment for the monthly amount you have chosen and the desired investment type, such as an S&P 500 index fund. After this, you can sit back, relax, and watch your investments grow. This long-term investment strategy will help ensure you meet your financial goals.