Dollar Cost Averaging



Warren Buffet, a legend in the investor space, has advocated for dollar cost averaging for certain index funds according to [1]. In relation to a study of formula investment plans around the Dow Jones industrial index, Lucile Tomlinson was once quoted as saying, “No one has yet discovered any other formula for investing which can be used with so much confidence of ultimate success, regardless of what may happen to security prices, as Dollar Cost Averaging” [2].

With statements and advocates like these, it seems that there must be something to dollar cost averaging. But what exactly is it? What are its pros? Are there any cons? And how could one get started with it?

What is dollar cost averaging?

Dollar cost averaging is a simple formula for investing wherein the investor purchases common stock every month using a consistent dollar amount to do so (e.g., $200 a month into a total market index fund).

Investing in this manner is a more hands off approach. It eliminates the need to try and “time” the market. If the market is going up, you keep investing the same amount each month. If the market is going down (even if it appears to be crashing), you still keep investing the same amount monthly.

This means that you’ll likely be investing when the market is overvalued as well as when it is undervalued. The thought is that the results, if investing in a total market or S&P 500 index fund, will average out to a net gain over the long run as has been seen time and time again in the past.

For example, take a look at the following S&P 500 graph that shows its long-term growth since 1981:

Image of S&P 500 gains since 1981.

Image provided by Google Finance

As can be seen, there are some periods where the earnings go down but the overall trajectory is up. If the trend that we’ve seen for decades with the S&P 500 continues, then periodic investments into an index fund like a S&P 500 index fund should continue to perform well in the long run.

An important note. Dollar cost averaging can be applied to many different types of investments. For the purposes of this article though, the only type of investments that will be discussed and endorsed are investments that cover a broad range of the US market like a total market or S&P 500 index fund. Individual corporation investments or other types of investments (e.g., Bitcoin) are not endorsed or discussed.

Example of dollar cost averaging

Let’s run through a quick hypothetical example. Say that I have $10,000 to invest. My plan is to invest this amount over five years into a S&P 500 index fund. $10,000 over five years would come out to $166.67 a month.

Month 10 I notice that the stock market is really starting to drop. Many investors are panicking and starting to sell their shares. I completely ignore this and continue to invest $166.67 a month.

Month 20 the stock market is starting to rebound and quickly. Investors are recommending to buy now. I again completely ignore this and continue to invest $166.67 a month.

At the end of the five-year period, some of the investors who tried to time the market did very well and came out with %15 in average annual returns. Others who tried to time the market did very poorly and lost a lot of money. But I made the average annual return of 8%.

Pros

There are a number of pros to dollar cost averaging:

  • Less risk of losing money in the long term (at least five years) for S&P 500 and total market index funds.
  • Unless you can beat the pros at timing the market (even the pros have a very difficult time with this), your chances of making money are usually much higher with dollar-cost averaging.
  • Less stress. You don’t need to continually follow the market. Just invest the same amount each month.
  • Less work for the same reason as above.
  • Has been shown in many studies to be highly effective when investing in funds that capture a large portion of the total US market.
  • Has been advocated for by some of the industry’s most successful and well-known investors.

Cons

There are still some potential cons with dollar cost averaging:

  • This investment strategy aims to achieve satisfactory results and to match the overall market gains in the context of S&P 500 and total market index funds. If you’re looking to beat the market, then this strategy may not be aggressive enough for you.
  • As with all investments, there’s no guarantee that you’ll make money and no guarantees that you won’t end up lose money.
  • While some appreciate a hands-off approach, others like to be more involved. This strategy doesn’t really cater to that crowd. Though, those who like to be more active may still want to consider using dollar cost averaging as the core of their overall investment plan.
  • Dollar-cost averaging is not a get rich quick method. You need to be in it for the long haul (at least five years) in order for the odds to be in your favor of making rather than losing money. If you can’t invest for at least that long, then it’s probably best not to invest in the first place.

How to get started

Many are already using dollar cost averaging without being aware that they are. The reason being that many 401k plans are configured such that a certain dollar amount will go into each individual’s account monthly. If that amount is being invested, then you are likely already using dollar cost averaging.

If you already have a 401k (or other similar retirement plan like an IRA) or are just looking for another way to invest using dollar cost averaging, then a couple great online platforms you can use are Vanguard and Fidelity

With Vanguard, a couple funds to consider are the “Vanguard Total Stock Market Index Fund Admiral Shares (VTSAX)” and “Vanguard 500 Index Fund Admiral Shares (VFIAX)”. These index funds have a minimum amount of $3,000 at the time of this writing. So, you’ll want to factor that in. But, both funds cover a large portion of the US market and are almost purpose built for dollar cost averaging. Vanguard is known for having some of the lowest management fees in the business as well helping you to keep more of your money.

Fidelity has similar funds to Vanguard including its “Fidelity 500 Index Fund FXAIX” and its Fidelity Total Market Index Fund FSKAX”. Fidelity also has low fees and is suitable for long-term investors.

Additionally, both Vanguard and Fidelity allow you to configure automatic payments for a truly near hands off approach.

Summary

Dollar cost averaging is a time proven investment strategy with a high likelihood of gains rather than loses in the long run when applied to total US market and S&P 500 index funds. It’s also one of the easiest investment strategies to follow and is endorsed by many giants in the industry. If you are not utilizing this investment strategy today, then it’s worth taking a closer look to see if it could be incorporated into your overall investment plan.

Sources

  1. USA Today - Warren Buffett has this advice for investing in a volatile market: Dollar-cost averaging
  2. The Intelligent Investor by Benjamin Graham - pg. 118