Who, What, and Why - Dollar Cost Averaging
Dollar cost averaging…it’s a fancy financial term that means buying stock (or funds) regularly regardless of price. It’s the idea that you don’t pull your money in and out of the stock market based on what you think is going to happen, or based on what is currently happening, but you continue to make regular, systematic (automatic - remember, that’s a big deal), investments no matter what is happening. Every month, every other month, every quarter, - you’re purchasing a designated amount of stock or mutual funds in a brokerage or retirement account. That’s dollar cost averaging.
And why am I sharing this with y’all? Because I know some of you like to pull your money out of the market, stop contributing to your 401k, change your investing activities when things go bad. Let me tell you why that’s a bad idea.
Dollar cost averaging (“DCA”) means that you’re investing, no matter what is happening in the world or with the economy. Whether there is a tsunami, or a pandemic, no matter what happens in politics or with the supply chain, you’re investing regularly and consistently. You're not timing the market - trying “buy low” and “sell high” - you’re consistently in the market. You’re also not buying in a big, one time lump sum purchase - because, if you time that wrong, then you could be buying when the market is high - again - timing the market. DCA ensures that you won’t time the market wrong, because you’re not timing it at all. You’re investing - regularly, which means sometimes, sometimes you’ll buy when the market is lower - and you’ll end up with more shares for your money. And sometimes you’ll buy when the market is higher; you’ll end up with fewer shares. But you’ll end up with regular, consistent investments over time. And that's always better than doing nothing.
Does dollar cost averaging “work”? That depends…
I'm a strong believer that finances should be automatic, it makes it easier to be consistent. And dollar cost averaging is the act of setting up regular, consistent investments that aren’t subject to your fears or feelings about current conditions. When you set up a regular investment, your money has an opportunity to grow in the market, without your interference. (Well, you could pull it out, but why would you do that)?? DCA allows you to invest manageable, bite-sized increments in the market without freaking you out, paralyzing you or forcing you to overthink it. Think of it as sticking your toe in the water - repeatedly.
But is dollar cost averaging the best way to invest? Again - it depends…
If you have a lump sum of money to invest and you have it sitting in a bank account, rather than growing in an investment - then perhaps DCA is not the best way to utilize those funds. If you have large sums of cash that aren’t allocated towards a particular goal, it may be time to figure out what that money should be doing. (Hint: it should not be chilling in a bank account if you don’t plan to use it within the next 5 years).
Dollar cost averaging might be for you if:
You don’t have a large lump to invest, but you’re interested in investing
You want to invest in the market, but you don’t want to try to time the market
You’re likely to get scared during market downturns and pull your investments
You’re likely to get complacent and “forget” to invest.
If you are participating in an employer-sponsored retirement plan, you’re already using dollar cost averaging. Your employer is investing your contributions in the market regularly and consistently tax-deferred brokerage account on your behalf. This tax-deferred status is the key difference between retirement accounts and other brokerage accounts. The funds invested in your retirement account are pre-tax (generally), which means that you’re investing them before they are reduced by taxes. In an employer-sponsored account, the dollar that you make is being invested. In a regular brokerage account, you’ve already paid taxes on the dollars that you’re investing. And that is one of the reasons that I advocate for retirement investing before other types of investing - the initial investment is tax free and the investment grows before being reduced by taxes.
Now - there is a whole conversation to be had about how much you should invest in a retirement account, compared to a “regular” brokerage account. But that’s a conversation for another day. For now, let’s agree that since retirement funds can’t be accessed until retirement, that you may need a brokerage account for funds that can be accessed at any time. Until next time…