Dollar Cost Averaging
Making lemonade from short term volatility
Risk continued
Over the past month or so, we’ve taken a look at risk and how we should perceive it, ignore the related volatility, and ultimately accept risk as part of the plan. We’ve talked about how risk unfolds over the long run and how volatility affects our investments day to day. While unnecessary risk should absolutely be avoided, we know that risk is the fuel that allows us to achieve the returns we need in order to 1) beat inflation and 2) pursue our dreams.
Riding out the wiggle
Avoid unnecessary risk, ignore volatility, and accept necessary risk. Simple enough right? Of course this all works well in principle (and better if you have a planner to guide you along the way), but these aren’t easy behaviors to adopt. Facing risk head on is a difficult task in itself, and even more difficult when your hard earned money is on the line. But of the three behaviors listed above, some are easier than others. From easiest to most difficult, they are:
Avoid unnecessary risk: By using indexed investments and pursuing a passive investment strategy, we can completely eliminate unsystematic (unnecessary) risk.
Accept necessary risk: While risk is difficult to accept, we should focus on expected returns and the valuable goals we are pursuing. Weighing risk against our important future can make it easier to accept.
Ignore volatility: This is the hard part. After avoiding and accepting risk, ignoring volatility is a task we have to face every day of our investment journey. The market rises and falls, our investments along for the ride, and the possibility of our goals in the balance. The temptation to sell/buy thrives on a daily basis, drawing us towards panic and away from our original investment decisions.
Make volatility a strength
What if this volatility wasn’t such a daily burden? What if volatility didn’t inspire us to panic and act in the short term? Most importantly, what if there was a way to reverse the feelings associated? What if instead of feeling euphoric when the market moves up, we feel calm? What if instead of feeling panic when the market falls, we feel opportunistic? Fortunately, there is a way to change how we feel (and behave) when faced with volatility. This is where dollar cost averaging (DCA) can help us.
Dollar cost averaging
Dollar cost averaging is one of those terms that sounds more complicated than is really is. In fact, chances are you are already doing it. If you have an employer retirement plan or make regular contributions to an investment account, then you’re already doing it. Dollar cost averaging is, simply, making regular contributions (typically monthly) to investment accounts. Monthly, regular, usually level contributions to investment accounts is the only requirement for this idea.
The good news is this type of investing is usually the easiest for most people. Since most of us rely on some sort of income spread throughout the year, DCA is usually the default way to invest for most accounts.
So if most of us do this already, and it is the easiest way to invest, why does volatility still sting? Why don’t we feel better about market movements? The answer isn’t in the behavior of dollar cost averaging, but rather how we perceive it.
Perceiving dollar cost averaging
Changing the way we perceive DCA is the key to helping us benefit emotionally from the effect. The good news is, not only does DCA benefit how we feel about investing, it has real tangible effects as well. Let’s look at the ways DCA helps us:
Reduces market timing risk: When is the right time to invest? Common wisdom says the best time is today (which is correct), but if you don’t have a lump sum to invest today, we are left wondering when we should spread out our investments in the future. By using DCA, we don’t need to worry. The market moves up, moves down, and we contribute a regular amount at regular intervals. Sometimes we buy high, sometimes we buy low, but over time the cost of the investment averages out. While you’re guaranteed not to buy at the very lowest point, you’re also protected from buying at the highest. Think of it as insurance against buying at the peak of the market. The premium paid is the lost opportunity of investing a lump sum at the lowest point of the market (which no one can predict… no one).
Mitigates emotional decision making: As mentioned, DCA hedges the emotional toll of volatility. While markets rise and fall, DCA allows us to confidently continue our investment plan. Since we know DCA helps smooth out the ride, we don’t need to worry about the bumps along the way.
Lowers cost per share: As mentioned above, DCA protects us from buying at the peak of the market. While we might end up buying some shares at high costs, the cost of the shares averaged out over each month assures us a fair price for our investments.
Simplifies investing: There’s a reason most of us are doing this already. By allocating a certain share of our income each month to investing, we are already participating in DCA. A steady income makes this easy to achieve.
Encourages regular investing: Since we know DCA has emotional and tangible benefits, we know it is a solid course of action. Each time we feel the pain of volatile markets, we can be assured we are already doing something about it. In a way, volatile markets encourage us to continue investing using DCA.
Greater chance of investing success: Frequent and regular investing is built into the heart of DCA. Not only does this type of investing help us digest volatility better, but it greatly enhances the chance of financial success overall. Since the greatest indicator of financial success is spending less than you make, using DCA as a long term investment strategy encourages consistent monthly savings, helping us pursue the very healthy behavior of spending within our means.
Enjoy the ride
No one knows the future. You don’t, I don’t, and there isn’t a financial planner or advisor that ever has or ever will. Since we can’t accurately predict the future, we have to rely on information and behavior to help us make (and keep) the best investment strategies for us. We already know passive investing helps us mitigate and accept the risk we must face, but passive investing alone won’t keep us grounded along the way. In order to find success in investing we must turn to behavior to get us to the finish line.
Through the market ups and downs, it’s hard to see the big picture and not panic. With DCA, we can change the way we feel about market volatility, be assured that we’re taking advantage of market downturns, and most importantly, nurture beneficial behavior along the way.
