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Dollar cost averaging

Lesson in Course: Investing basics (advanced, 6min)

I am ready to start investing. Should I drop all my money in at once? What is an easy buying strategy for starting today?

Eureka!

What it's about: Dollar-cost averaging is a simple strategy for lowering the risk of buying an investment at the wrong time.

Why it's important: This strategy prevents us from having to overcome losses from mistiming the market.

Key takeaway: Going all in is risky. Making our investment in 4 to 10 increments over time lowers that risk.

When we have identified a good investment opportunity, it's often too risky to put all our money in at once. How many times have we heard of a friend or someone we know buying shares, and then the market drops right after? Trying to time the markets is difficult, and dollar-cost-averaging lessens the pain when we get it wrong.

What is Dollar-cost averaging?

An investment strategy where we make smaller investments over a period of time, rather than making a bigger one-time investment. This strategy reduces the risk of mistiming the market.

How does it work?

https://www.youtube.com/watch?v=ZFEnwg54Zj4

By breaking up our initial lump sum investment into equal payments, we can spread out our purchases to reduce our risk to market movements. The strategy is especially helpful if the market dips while we are buying.

DCA in action

Let's say we have $5,000 that we want to invest in the US stock market. Suppose we've decided that SPY, an ETF that tracks the S&P 500 is the right investment for us. Here's how we could make our investment using dollar-cost averaging:

  1. Break up our total investment amount into small pieces. Let's go with 5 "lots" of $1,000 each.
  2. If we're long-term investors, we would buy $1,000 worth of SPY today
  3. Then buy another $1,000 worth one month later.
  4. Repeat until all $5,000 is invested

Now let's say SPY is worth $110 today and these were the prices for SPY each time we bought it:

  1. $100
  2. $95
  3. $97
  4. $102
  5. $106
  • Without DCA, we would have bought 50 shares of SPY at $100 each for $5,000 total. At today's price of $110, our investment would be worth $5,500. 
  • With DCA, we would have bought 50.1 shares of SPY at those various prices for $5,000 total. At today's price of $110, our investment would be worth $5,508.

DCA helped us here because we were able to buy more shares of SPY when the price dipped in the 2nd and 3rd months before going back up.

 
Examples of dollar-cost averaging
  • Setting your 401(k) to auto-purchase the same investments every deposit
  • Buying $1,000 worth of AAPL shares every week over 4 weeks
  • Investing $500 every month into a government bond fund

The tradeoff

Like any strategy, there are some disadvantages to dollar-cost averaging. We are trading our possible upside returns for some downside protection. For instance, if the price of an investment keeps going up after the first day we purchase it, then our returns are going to be lower than if we had just made one lump-sum purchase.

 

While not perfect, DCA is a great way to get started because it's simple and not time-intensive.

Actionable ideas

Dollar-cost-averaging every month can be an effective strategy for long-term investors, while dollar-cost averaging every week or every 3 days can be an effective strategy for short-term investors.

A quick rule of thumb is no less than 4, and no more than 10 increments. Deploying more than 25% (4 increments) of our investment capital can still expose us to market timing risks. More than 10 increments can mean that we have stretched out our investment over a period of time that's too long and things may have changed so that the investment is no longer a good one.

Supplementary materials

Here is another video that goes more into more detail about how dollar-cost averaging works over a period of time. It's an 8-minute video but the video explains the emotional advantages of dollar-cost averaging.

https://www.youtube.com/watch?v=vLTdlN7VJTM

Glossary

What is Dollar-cost-averaging ?

An investment strategy where we make smaller investments over a period of time, rather than making a bigger one-time investment. This strategy reduces the risk of mistiming the market.