We are all human here, right? 🙂 And one thing you can always count on with humans is that we are emotional beings. We experience fear, pride, lust, greed and everything in between.
What the heck am I talking about? I’m talking about investment strategy!
Investing is one of those financial musts to get ahead yet it stirs just about every emotion humans are capable of feeling. When thinking about possible returns, you will get excited, enthused and even start to feel greedy…to think you will be able to retire fat and happy with a boatload of money! What a joy that would be. But investing also produces fear, anger and confusion because investing is difficult to understand and if you fail at it, you could lose everything.
What if there was an investment strategy that could disconnect you from the emotional side of investing and still provide results? I am talking about Dollar Cost Averaging. This investment strategy solves two of the most common problems with investing; emotion clouds judgment and the general unpredictability of the market itself.
Let’s address these issues one at a time.
Humans and our emotions
We have all seen what emotional investing can do. During the meltdown of 2008, it seemed everyone was pulling out of the market. Weathered investors were tossing fine tuned investment strategies to the wind because they stopped listening to their brains, and started thinking with their emotions.
“Be fearful when others are greedy and greedy when others are fearful” – Warren Buffet
The fact that everyone was pulling out of the market (fear) caused everyone to doubt the stability of the country. The economy took a dive and the rest is history. That is what emotional investment brings to the table. A plan is worthless if not followed through and when emotions like fear, or even greed interfere with an investment strategy, then you are better off dropping your fortune on the roulette table in Vegas.
Emotion aside, the unpredictability of the market throws a wrench into the gears.
The unpredictability of the market, and the reverse of humans
You will never be able to accurately predict the market. You may be able to guess a stock here or there but the second you make a bad guess, and lose $80,000 on that guess, you may rethink your lack of strategy.
The market will never become more predictable…so how do people make any money in the stocks?
One way is Dollar Cost Averaging
Dollar Cost Averaging is investing a set amount of money over a set period of time, regardless of what the market does. By doing this, your portfolio will average out the major ups and downs of the market to create more balance and reduce risk. The strategy works best for buy and hold investors.
I am not an investment guru but this strategy is pure logic and is one of the best ways to go for the regulars like you and me that are not only in it for the long haul, but want to avoid the stress of trading while still making money doing it.
This strategy, coupled with other investment rules of thumb such as having a diversified portfolio, can ease you into the market and mitigate much of the risk of going at it without a strategy at all.
Let me give you two scenarios to illustrate the strategy.
Scenario A: Timing the market
You have $1000 set aside each month to invest in the stock market. You watch the market and do your research. You pick a company that you want to buy and it looks like a sound choice. They have a good running history and look to be doing well, but seem undervalued. Great. The next step is to actually put that money into action and buy stock in that company. You continue to hold off, watching the companies ticker for that big dip when you will get in, but the stock continues to rise. You start to feel like you are missing out on the opportunity. You get nervous and your emotions start to take over. Time is ticking and you decide to just go for it. The stock is nearing it’s 52 week historic high but you don’t want to miss out on gains as it continues to rise! You go for it…pumping that $1000 you set aside for the past few months into this golden goose. To your dismay, in the following days, your company announces a change in direction into within the company, and the stock price begins to decline!
“It’s ok”, you tell yourself as you watch the little red ticker sink lower and lower each day. “The company will turn things around. The public will eventually take a liking to what the company is doing now and the stock will start to go back up…right?” You wait, and watch. Fear takes hold again and you can’t stand to see any more of your money lost on this poor choice…on this failure…so you sell…
Well, just like you said, the public took notice of the companies new direction and the stock started to gain value again. The stock went back up, even higher than when you bought it. Not only did you lose potential gain, you lost your investment money by selling at the bottom.
Scenario B: Dollar Cost Averaging
You have that same $1000. You decide you aren’t “that guy” that has all the luck, so you set up an automatic investment strategy. Your $1000 will be invested into the company of your choice, at $250 chunks each week. You will leave that account alone and let it do it’s thing, checking it periodically out of curiosity. You insist to yourself that you won’t meddle with the plan you have put in place. You will let that account continue to invest automatically, every week, for the next year then review your progress.
You continue to watch the stock ticker of the company you have chosen but you swore to let it ride. Each week, with the shifts in the market, your company stock shifts. One week it was way up, the next it dropped a little, and the next it was well below the 52 week low.
At the end of the year, you review your progress. After checking the general standing of the account, which is overall very positive, you investigate how this happened, with all the ups and downs of the market.
With Scenario A, you lost money, were an emotional wreck, and developed an ulcer from the stress. Your emotions took over while trying to time the market and you ended up with a big loss.
With Scenario B, you gained a profit, were able to relax and watch your money grow and emotion had nothing to do with it. Sure, you felt a bit stressed when the market went down. We all do! But you had a strategy, stuck to it, and in the end came out golden.
Here’s why it works
There are a couple things you need to understand about Dollar Cost Averaging. First, because you set this up and let the computers take over, you aren’t actually “pulling the trigger” on any decisions. This puts emotions in the back seat and distances you from the actual process. That’s a good thing.
Second, because the plan is a long term strategy and doesn’t rely on the market itself when making decisions, you aren’t timing the market at all and the volatility of the market will have much less effect on your portfolio’s overall gains.
And third, why you will profit from this strategy is because while your money is being invested automatically at set intervals, the stock price is changing. But you have a set amount to be invested so when the stock price is higher, you will buy less shares; when the stock price is lower, you will end up with more shares. Getting more shares at a lower price and less at a higher gives your portfolio more opportunity for that stock to climb when it’s low and won’t allow you to buy a large amount when it’s high so your potential for a huge fall is limited.
As long as the company stock gains overall for the period of time you are investing in it, regardless of the market ups and downs, you will generally come out with a profit.
A great way to dollar cost average stock purchases is with ShareBuilder’s automatic investing. Check it out!
What do you think of dollar cost averaging?
Jesse Michelsen, who writes at Personal Finance Firewall, is a regular guy with a family. He has a modest stock portfolio and does what he can to reduce risk while still planning out his retirement. This is his interpretation of Dollar Cost Averaging and why it works but it is also opinionated. Disclosure: Investing comes with risk. This blog, nor this author, can be held responsible for investment loss. Do your research before investing!
Money Obedience says
I agree that dollar cost averaging eliminates emotions since you put your investment plan on auto-pilot. Fear and greed won’t come into play. But it does not eliminate market risk. As a matter of fact, anytime you add money to stocks or bonds via dollar cost averaging you increase market risk.
That’s true, MO, nothing out there will eliminate market risk, but with dollar cost averaging, you are less likely to take a HUGE hit because you aren’t investing your entire lump sum at one time.
If you dropped $10,000 into the market the day before a crash, you would take a big hit. If you dropped that same $10,000 spread out over 10 months, you may take a big hit one month (on a smaller sum), but chances are, the other 9 months of investment will balance that out.
Agreed. DCA won’t eliminate risk entirely but it can help to mitigate it. With dollar cost averaging you are taking the timing out of the market and in the long run this helps eliminate market timing risk.
Just a note, this post does not include every aspect of Dollar Cost Averaging. There is a cost associated with Dollar Cost Averaging for most brokerage accounts because each transaction incurs a fee. If you trade a certain number of times a month, or have a certain balance, that fee is greatly reduced but for those starting out in investing, spreading your investment choices over months versus weeks can help balance out the cost of transaction when Dollar Cost Averaging.
It also helps to have a brokerage account with low fees to begin with 🙂
ShareBuilder offers automatic trades for $4 and TradeKing has trades for $4.95 😉
Sounds like this might also be a good option for inexperienced stock buyers. If you’re making less decisions, then it would be easier for you as a first time investor, right?
Absolutely, many people learn about DCA as a way to ease into the market as an inexperienced investor, but there is no reason to stop using it once you gain some experience trading as it can bring great long term results.
Being an experienced trader doesn’t mean you only pick individual stocks. You can be experienced and still buy market indexes at specific times in the year to add to your portfolio.
What I’m getting at is using dollar cost averaging isn’t just for new investors; it’s a strategy that can be used by all levels of investors.
Financial Samurai says
Nice article Jesse! Humans are really emotional, and it’s ridiculous how often we sell at the bottom and buy at the top!
That’s why we need DIFFERENT buckets of asset classes.. so we don’t blow ourselves up.
I’ve got roughly 30% of my total net worth in equities. The rest is in cash and real estate.
The greatest earner is simply my job!
Thanks Sam! Much appreciated 🙂
When I read stats of individual investors versus the indexes I was shocked at how low there were and how much money was lost on average. You would be better off just buying the indexes that trying to time the market yourself, with those averages.
Most of my net worth is in real estate and cash as well, and we have the same top earner!
I think dollar cost averaging is a good strategy. I pretty much do that, although I always find myself tempted to buy more (and I sometimes do) than planned when prices are very low.
A little instinct thrown in here and there is never a bad thing 🙂 I just wouldn’t rely on it as your complete strategy. If share prices seem undervalued for a company, you could always add them to your automatic DCA strategy too.
Budgeting in the Fun Stuff says
I didn’t know what it was called until last week, but apparently we sort of dollar cost average, lol. We automatically contribute and invest $300 a month into our Roth IRA and then dump the remaining $1400 a year in whenever we feel like it. This allows for us to spread out the “big hit” risk, but still invest more whenever the market has a big crash and we feel we can get a discount. 🙂
Way to go! As long as you have as strategy, stick to it and put emotion aside, things should turn out great. Also ,you bring up a good point about putting a regular amount into your Roth. Most retirement accounts (Roth, 401k) have the ability to be invested in index funds. These have a built in ability to DCA and as you contribute, they drop that money into stocks they choose. It’s a good strategy and really simple..the problem with this is when people see their 401k take a huge hit, they freak and pull out all their funds. This causes fees and also takes away the opportunity for them to average out or gain from the upturn of the market, after a crash..
Anyway, keep it up 🙂
Seems like no matter what you do, if your investing in stocks you need to prepare yourself for the emotional roller coaster that will happen, the ups and the downs and using this strategy might be one tool to help you keep your sanity.
It certainly can be a roller coaster 🙂 I had a friend that lost the equivalent of two years of my salary, in one day. He was scarred for life, depressed and never went back into the market. You really have to find any way you can to limit the emotional impact trading can have on your life, and this can help in my opinion especially over the long term. If my friend had stuck, his money would have eventually come back but he was too struck with fear that it would not recover, he sold, losing all chance of regaining that loss.. (this was years back)
@Jesse – Oh man, that makes me sick to my stomach. I can’t imagine what your friend must have felt like!
Ya, his whole family was a wreck for a while, but he’s retired now and I’m sure doesn’t think about that too often 🙂
It can definitely be a roller coaster. That’s why a type of “set it and forget it” investing can help and dollar cost averaging can do that. You should still keep up with your investments but sometimes it’s not so good to see the day to day movements.
The concept is interesting, but I think it goes more to one’s emotions than the numbers. Over a sufficiently long time, the market grows at X% and a lump sump will return that X yet DCA, if done over say two years will lag by about that X%, i.e. one year’s growth.
That said, when counseling a new investor, I always suggest they DCA into the market over a few years. If it takes off they miss a portion of the gain, but if it crashes, that averaging in feels a lot better.
I think if you play enough with the numbers you can find argument to any investing strategy. A person really has to figure out how they feel about investing and what they can tolerate as well as the best strategy that works for them.
As mentioned earlier, most with a 401(k) or similar plan dollar cost average in each of their pay periods.
Joe, there is absolutely no substitute for proper research with any investment strategy and they all carry risk, but for entry into the market, DCA is a great starting point like you mentioned. There are better platforms for higher gains, but as a good balanced strategy, it works.
Dollar cost averaging can help to take some of the edge of in investing. The key is to stick with your plan and weather the storms as well as enjoying the success you will encounter.
Absolutely! You have to stick with your plan, whatever it may be!
Steve Austin says
The proper emotional attitude when purchasing stocks (using any strategy) is that you have already lost your money. Of course, you won’t always (and not even so often) lose your money, but you must be emotionally prepared to do so…just in case. When you invest in stocks (a long term vehicle), your capital is no longer capital; it is an earnings and dividend returning financial vehicle. The capital may or may not come back to you, and if it does come back to you, *how* it gets there is most often non-linear and unpredictable. It’s only capital again when you sell.
Regarding DCA, I have studied a useful cousin called DVA: http://en.wikipedia.org/wiki/Value_averaging
I hear you about going in with the thought that you lost your money but I’m not sure I agree. If you believe in a company and did your research then I don’t believe you should think of it as lost money. Perhaps a better way to say it is you should keep detached from the money and let it do what it needs to?
Steve Austin says
Certainly more than one way to say it. With the phrase “let it do what it needs to do”, I have to ask “for how long?” If the answer is “indefinitely”, then I’m on board. One never really knows how long it will take to achieve some absolute or relative sell point.
True, if we could tell the best point then we would all do awesome in the market (or not since we all would know). Still, I would think someone using dollar cost averaging would be looking to invest for the long term.
I’ll have to take a deeper look into Dollar Value Averaging. Seems interesting but also a bit more complex than dollar cost averaging.
DVA does sound more complex but very interesting. I love when a great idea evolves into an even better idea!
The mantra I go by, though, is “invest only what you can afford to lose”. I only invest “play money” and anything I gain from that is a big fat bonus!
Every kind of investment does come with some risk, and each person must decide individually if they feel they can handle those risks. While no one can plan for every eventuality, hopefully having some kind of investment cushion will help. You can learn more about DCA or the numerous other kinds of investment at http://www.mutualfundstore.com/dollar-cost-averaging. Good luck!