Average is pretty good
If you've actually heard the term "dollar cost averaging" before, then you've probably already dipped your toes into the world of investing — or at least have begun your research.
If this is new to you or you're still trying to figure out what it is, lets look at some names that might actually make more sense:
"The Kick Fear in the Face Approach to Investing"
"The Refusal to Time the Market Because That's Cray Investing Strategy"
"The Buy Every Month and Don't Worry About the Price Investing Strategy"
Okay, so maybe these terms don't exactly clarify the meaning either, but at least they get to the heart of the matter.
Dollar-cost averaging is an investing strategy where you invest a fixed amount of money over a period of time so you don't have to worry about buying into the stock market at the wrong time.
What's the Deal With Dollar Cost Averaging?
Trying to make money through investing requires two things: buying in at a low price and selling at a high price.
Simple, right? Pay less, sell for more, turn a profit.
Of course, the term "low" or "good" as it relates to prices in the stock market are relative. Who's to say what a good price even is?
That's something most of us don't discover until later after we've seen the value on our investments go way up (or way down). And those numbers can change on a daily basis.
Developed to mitigate the risk of entering the stock market at the worst time. This strategy says forget about price.
Instead, simply buy in at the same time and amount every month and, eventually, the average price you pay will even out all the bumpy fluctuations that happened over the year.
It allows you to get off the stock market price roller coaster and instead, focus on things that actually matter.
Deploy that cash
This strategy can be deployed in two instances:
Divide and Conquer
You're sitting on a lump sum of money you'd like to invest, and you can't decide when's the right time to put it into the market.
Dollar cost averaging would say divide the dollar amount by the amount of times per year you choose to invest (once per month, say, or week, or quarter, or whatever interval is most comfortable for you).
Then invest that amount at that pace regularly throughout the next year.
Periodic Deposits
If you aren't sitting on a lump of money, you can still use this strategy.
You can automatically deduct money from your paycheck to put into an investment account or a 401(k), again, the same amount each time and on the same day(s) each month.
But, is this the best investing strategy?
Now onto the question you've probably been wondering about: Is dollar cost averaging a better approach to investing?
If fear is your number one detractor to investing, the answer is yes.
Many people procrastinate on investing their savings because they fear that they'll lose it all if they start at the wrong moment.
Dollar cost averaging presents a solution to that fear by telling you to invest a little at a time at a regular pace. It helps you just get in there and get your feet wet so you can, at the very least, start investing.
As for the question of which strategy makes the most money on your investments, that answer gets more complicated …
Alliance Bernstein shares in their historical comparison of lump sum investing versus dollar cost averaging versus holding cash, measuring over twelve-month periods:
So yes, historically investing one big lump sum at once turns a bigger profit but dollar cost averaging crushes cash.
Cash Is Still the Riskiest Investment
If you avoid the stock market because you're afraid to lose your money, consider this:
Thanks to inflation, the value of cash will decrease over time. That means you need more money in the future to buy the same thing you could today, for less.
Even with the volatility of the stock market, historically it increases significantly over the long-term.
So if you're keeping your entire life savings in a bank account, the value that your dollar holds (meaning how much it can buy) will go down over time, even as your savings increases.
Go ahead and plug your current savings into this inflation calculator to see how much it was worth the year you were born. Go on, we'll wait.
Shocking, right? (Not the year I was born, the dollar amount.)
Now imagine how much you'll need your savings to grow to keep pace with that difference.
In the end, the best investment is the one you make.
Investing blows cash out of the water. So you'll do better if you invest your cash than if you keep it in a bank account, period.
You might not have a lump sum of money to invest yet. Which means dollar cost averaging out of your paycheck each month could be the easiest way to get into the market at all.
But the most important question to ask yourself is this: What is my goal?
If your goal is to invest but you're nervous to do so, dollar cost averaging is the most user-friendly way to get your foot in the door.
At the end of the day if you have room in your budget to save money each month, getting some money into the stock market is better than waiting until you land on the perfect time or perfect strategy.
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