At the risk of answering the question in the first line of a blog post, dollar cost averaging is an investment strategy, where an investor places a fixed dollar amount into a given investment on a regular basis. The investment is then made each and every month, for example, regardless of what is happening in the financial markets.
The result is that more shares are purchased when prices are low, and fewer shares are bought when prices are high. And for many clients, we think dollar cost averaging is the best way for them to responsibly build their portfolio over time.
However, I've heard the term misused a number of times in the past, and so I wanted to devote some time to what 'dollar cost averaging' is and why it's worthwhile.
The myth of dollar cost averaging.
My wife and I were at dinner with some friends a week ago, and they started talking about the stock market. Now, I generally don't bring up the stock market while I'm out socially because I understand that it doesn't always make the most riveting dinner conversations, but since I do find it quite fascinating, I'm always happy to indulge others.
Anyway, one of our friend's was talking about their position in GoPro (NASDAQ: GPRO) and how they were continuing to buy more of the stock as it declined. Even though they were losing money on the stock, the rationale was that they were also lowering their cost of ownership as the stock declined. "Dollar cost averaging!" our friend mistakenly exclaimed.
How does it work?
For those that aren't following me, consider that you spent $10,000 on a $100 stock of which you now own 100 shares. If that stock declined to $50, your investment would now be worth $5,000, but you'd still have 100 shares. Now, if you bought another 100 shares at $50, it would only cost you $5,000 - but you'd have twice as much stock now. In total, you'd own 200 shares and have spent $15,000.
The logic is that you've gotten a better deal on the stock because you've gotten it at such a great discount. After all, on a weighted basis, you now own 200 shares at a cost of $75 per share.
This often makes people feel great because when they look at their investment statement, it feels like you don't own a $100 stock that trades at $50 - but are instead holding an $75 stock that trades at $50. And, after all, if the stock goes back up to $100, you won't just break even - you'll have made a great profit.
This is terrible advice.
This is bad logic, and it can be dangerous, especially if you're dealing with individual stocks. That's because these stocks have the ability to decline further, and if you keep buying into them, your tying up an increasingly large percentage of your worth in a company that is declining. It's like the idea of going to Vegas and doubling your bet size every time you lose a hand of blackjack. You may swim out of it nine-out-of-ten times, but on that tenth time, you'll go broke trying to dig yourself out of a hole.
So what is dollar cost averaging?
A key difference between the above example and when dollar cost averaging is at it's best, is your 401(k), where you have a set amount of money regularly deposited into it and invested at whatever price the market is trading at.
And since you're investing into a diversified bundle of securities, and not just one stock, the real risk isn't that your portfolio goes to zero, but rather that you'll have to manage your liquidity needs, such as making sure that you don't have to buy a house with that money while the market is down - but will instead be able to keep saving money into your investment account at that time.
It's this discipline that defines 'dollar cost averaging,' and it's why I don't feel that you can apply it to an individual security.
What are the benefits?
I think that there are three main benefits to dollar cost averaging, which are:
- It prevents procrastination. Many people either ignore their investments or just have a hard time getting started. I think that most people know they should be investing for their kids or their retirement, but it's hard to get around to it. And if you wait until you have a large sum of money before you want to invest it, you'll most likely find that you'll never have a large sum of money.
- It minimizes regret. Money and emotions often flow together, and even after two decades investing in the market, it's easy to feel regret when an investment proves to be poorly timed. The only thing worse is when you use that regret to disrupt your investment strategy in an attempt to make up for the setback. Through dollar cost averaging, because you're always investing in the market, your identity of an investment's worth is less anchored to one perceived value, and therefore has less of an emotional impact on you.
- It avoids timing the market. Dollar cost averaging ensures that you participate in the good times and the bad ones. While this doesn't guarantee a profit or protect against a loss, it does eliminate the temptation to try for random, long-shot strategies that seldom succeed.
Conclusion.
There are a number of ways for people to successfully invest in the markets, and dollar cost averaging is just one example of that. But, if you like the discipline of investing small amounts of money as you earn them, there's something very satisfying about regularly socking money away into an investment account. Or, if you're prone to regret after a large investment has a short-term drop, it's worth recognizing that dollar cost averaging helps to minimize the emotional impact of investing.
