Author: David

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Dollar Cost Averaging – Safe Investing

Posted on by David

In the last post we discussed investing even though we don’t know whether the stock market will go up or down. So how do you invest knowing that you don’t know what the future holds? The answer is dollar cost averaging. The idea of dollar cost averaging is spreading your investment out versus dumping it all into the market at once. If you have $10,000 in cash that you want to invest in the market you can invest it all at once or spread it out over time. It can be scary to invest it all at once since you don’t know if there’s going to be a crash in the near future.

A safer option for investing that $10,000 is to spread it out over several months. Let’s say you average it across the year. This option would have you investing $833.33 every month. If a market correction occurs, say, in month 6, you still have 6 months to invest afterwards when stocks are cheaper. Dollar cost averaging works to minimize fear of losing your hard earned cash.

Pros and Cons of Dollar Cost Averaging

Because dollar cost averaging is a safe way to invest in the market it’s not as potentially lucrative as investing all your money at once (called lump sum investing). If the market is increasing in value, lump sum investing will get you greater returns because you are riding the market all the way up. If you average your investments out over time, you will be buying stocks as they keep getting more expensive. As you can see in the bull market from 1995 to 2000, it was a better idea to invest in the market all at once.

Lump sum investing wins out in 2008-2013.
Source: millennial-revolution.com

But this isn’t always the case. The obvious fear is of a market crash or correction. No one wants to invest a bunch of money only to see that investment dwindle. This is where dollar cost averaging shines. Like I’ve said before, no one knows when a correction will occur. But beyond that, no one knows when the correction will end. Where is the bottom? Take the housing crash of 2008 for example. If you were waiting for a correction to invest a bunch of money you were in luck.

By September of 2008 the S&P 500 had dropped about 20% from its all-time high. That seems like a pretty good time to invest, after a 20% drop. But little did we know that in the next month the S&P 500 would drop another ~30%. You’d feel like a real fool dumping a bunch of money into the market right before a 30% decline. Like I did in February of 2020.

The other side of the coin is maybe you’re too cautious during a market correction and you keep anticipating another drop. By February of 2009 the S&P 500 started going back up and it kept going up for years and year. What if, out of caution, you waiting until 2010 to get back into the stocks? You would have lost out on ~45% in gains.

Dollar cost averaging wins out in 2008-2013.
Source: millennial-revolution.com

This is why dollar cost averaging is the safer method. You don’t get the full potential of a years long bull market, but you also greatly soften the blow of a market crash. Lower risk lower rewards. But most important dollar cost averaging reduces the fear of investing by eliminating market timing. In the 2008 – 20013 scenario dollar cost averaging beats out lump sum investing by about 35% or about 7% annually.

Reducing the Fear of Investing

The most common reason given for not investing in the stock market is fear of losing money. But the reality is that not investing in the stock market is the best way to lose money. Even if you’re a terrible market timer, and every time you put money into the stock market it goes down, keeping it in there is a better a option than leaving it in a savings account.

Charles Schwab ran a series of models for five different hypothetical investors. These five investors each started the year with $2000. The first model invested all $2000 at the market’s lowest point of the year (perfect market timing). The second invested all $2000 at the market’s highest point of the year (terrible market timing). The third just invested his money on January 1st (lump sum investing). The fourth used dollar cost averaging. And the fifth kept all his money in a savings account. This was repeated for 20 years.

The only loser is the one who doesn't invest.
Source: Schwab Center for Financial Research

The results are interesting to say the least. Obviously perfect timing comes out in the lead, but surprisingly it’s only about $15,000 ahead of just investing the $2000 immediately each year. What’s even more surprising is that the lump sum investing strategy beast out dollar cost averaging by less than $1,000 (~0.3% difference). If dollar cost averaging makes you more confident and less fearful when investing then it’s definitely worth it. Even terrible market timing beats out a savings account by a factor of almost 3 to 1.

The only loser in this scenario is the the person who fails to invest in the market. The majority of people who don’t invest, don’t do it because they are afraid of losing money. They fear the risk. We’ve seen how a family with a modest income can retire in only 20 years. If they don’t invest in the stock market and only use a savings account. It will take them 100 years to reach a million dollars. If they’re looking to have zero risk, they’ve got it. They will have zero risk of retiring.

Far more money has been lost by investors trying to anticipate corrections, than lost in the corrections themselves.

Peter Lynch

Most People use Dollar Cost Averaging

The greatest pro that dollar cost averaging has going for it is that it reduces the fear of investing. Because there is no longer have the fear of an immediate market crash, an investor can feel more comfortable investing.

Despite the pros and cons, it should be noted that the vast majority of people use dollar cost averaging when they invest in the stock market. Chances are you already do it without knowing. If you have a 401(k) you most-likely automatically contribute to it bi-weekly out of your paycheck. That is dollar cost averaging. You’re spreading your investments out across the year (and essentially your whole career). This means that you’ll always be investing before, during and after a market crash. You don’t have to worry about dips in the market because you are regularly investing and holding them for years or decades.

Conclusion

In our last post we discussed the futility of market timing and asserted there was a better way. If you have no fear in market crashes I guess lump sum investing is the way to go. But if you’re like the rest of us and have a fear of losing your hard-earned savings, dollar cost averaging is a safe way to invest in the stock market. It helps ride out the volatility of the market and it’s simple to do if you have a 401(k).

The outcome of Schwab’s experiment surprised me. I expected the order to be the same, but I didn’t expect the actual values to be so close. The different between lump sum investing and dollar cost averaging was negligible and even the difference between perfect and bad market timing were not that large.

What do you think? How do you invest? Is it scary knowing the market could drop? Let us know in the comments below!

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Market Timing is Stupid

Posted on by David

When is it a good time to buy stocks? For the savvy investor the answer is “when stocks are cheap.” After all you want to buy low, sell high. But how do you know when stocks are cheap? How do you know when they’re expensive? The ability to buy low and sell high is easier said than done. Trying to determine the best times to buy and sell stocks is called market timing, and I’m here to tell you that market timing is stupid.

If you knew the stock market was going to crash next month, you would probably not invest in stocks right now. Knowing that the stock market traditionally always goes up eventually, you would wait until after the crash then invest in stocks. On the other hand, if you knew that the market was going to skyrocket next month, you would be socking away all the money you could in order to ride the wave upwards. If only we knew in August of 2019 that in 2 years Tesla would increase by over 2000% and Elon Musk would be worth more than Bill Gates and Warren Buffett combined!

The problem, of course, is that no one knows what the stock market is going to do tomorrow, much less months or years from now. If you were able to know then you could be worth more than Bill Gates and Warren Buffett combined.

Fancy Guestimation

The closest thing we have to knowing the future is data analytics. Based on past performance and future estimates, market analysts can guess where the market is going next. But that’s all these are: a guess. Several big-name firms have published their guesses for how the S&P 500 will look at the end of 2022 based on their own models and data analytics. As it stands right now, the S&P 500 is at about 4500.

Investment FirmS&P 500 Prediction for the end of 2022
Wells Fargo5,100-5,300
Goldman Sachs5100
J.P. Morgan5050
Bank of America4600
Morgan Stanley4400
Five top investment firms’ prediction for the S&P 500

The first thing you’ll notice here is that the spread is a whopping 900 points. That corresponds to a 20 percentage point different between Wells Fargo and Morgan Stanley! That’s a big difference considering the long-term average for the S&P 500 is 7% increase per year.

So how do five well-respected firms come up with such a large spread in possible values? They’re all using the same data. All the information is published and accessible to the public. It has to be public because insider trading is illegal. So why aren’t these predictions more or less the same? The answer is they’re all just guessing.

The function of economic forecasting is to make astrology look respectable.

John Kenneth Galbraith

So What do I do With This Information?

What does this have to do with market timing being stupid? Well what if Wells Fargo or Goldman Sachs is correct and the stock market increases by 13%-18%? That would be great I’d put all of my money in the S&P 500. But what if BofA or Morgan Stanley is correct and the stock market stays flat for the year or worse goes down? You’re less eager to throw your life savings into the stock market.

Some people borrow money to invest. This is called “margin” and is a bad idea for the following reason. Let’s say you think Wells Fargo is correct and the market is going up up up. You’re so set on this that you borrow a large sum of money and use it to invest in the market. If you make gains on that money then you can pay off your loan with the gains you’ve made and keep the extras.

But let’s say instead Wells Fargo was too optimistic and instead the S&P 500 falls to 4200. Not only have you lost money in the stock market, you lost the money you borrowed. Now you’re in hot water when the bank comes calling on its debts. Never invest money you don’t own. Remember, the Wells Fargo analysts don’t know what the market will do. If they did they would be the richest people in the world rather than Elon.

But what about the other option? Instead of Wells Fargo, let’s say you think Morgan Stanley has the right idea and the market is going to drop. You’re afraid of a market crash so you stop investing and you pull all your money out of your 401(k). You don’t want to lose your life’s savings so you conservatively stuff that cash in your mattress.

Let’s say after you do this the S&P 500 does hit 5300. You’ve just lost out on 18% gains. And now you have a large sum of money that you have to decide what to do with. Do you put it back into your 401(k) and invest it in the market? You’ve already missed that 18% gain, maybe the market will drop 11% next year to correct to it’s 7% annual average? do you risk investing in the market now or play it safe another year?

Still waiting...

Market Timing can be Paralyzing

You can understand how market timing can be paralyzing. Waiting for the perfect time to invest in the market will leave you old and poor. Either stocks are overvalued and it’s not a good time to invest or stocks are crashing and it’s not a good time to invest.

People have been saying since 2017 that the stock market is overvalued and is due for a correction. A correction happened in December of 2018 when the market dropped about 12%. But if you waited for that to happen you would have lost out on 2017’s 19% gain. The desire to wait for a crash would have meant a loss of 7% compared to just investing when you had the money.

Or what if you noticed that the world was starting to be afraid of a novel coronavirus in February 2020. Between February 21st and 28th 2020 the S&P 500 dropped 12%. As a savvy investor I decided to “buy the dip” and invested a chuck of change during that time. What happened next? The S&P went down another 22%. Well that felt dumb. You can see how market timing very rarely works out favorably.

Luckily for me the stock market shot back up from its March lows and I made some money. But looking back on it now I would have made just as much, if not more, if I had just invested that money a couple months prior in 2019 rather than wait for a market correction.

It just doesn't work

How do I invest?

The point is no one knows what the future holds. Not you, not me, not J. P. Morgan. Only God is Omniscient so we must invest accordingly. We invest in broad market index funds like a total stock market index fund or an S&P 500 index fund because the market generally goes up over time. There are dips and corrections, but statistically the market increases by about 7% every year. And if we’re investing for 40 years those dips and corrections will hardly register on the radar. And if a total market index fund does go to zero it means the world has ended and you have more important things to worry about like where you’ll spend eternity.

The market could go up or down, but since we’re confident it will statistically keep going up, it doesn’t matter when you invest, it only matters that you do invest. An old adage says, “The best time to invest was yesterday, the next best time is today, and the worst time is tomorrow.”

The best time to invest was yesterday, the next best time is today, and the worst time is tomorrow.

A market crash is coming. It may be soon or still far off. It’s possible the new Omicron Covid variant may prompt countries to shut down and cause stocks to tumble. Or maybe we’ll see another decade-long bull market. We don’t know what will happen so don’t try to time the market.

Conclusion

Market timing is stupid since we don’t know the future of the stock market. But how do we prudently invest without risking our entire life savings? The answer is dollar cost averaging which I’ll explain in the next article.

What you do think? Not knowing the future, how do you invest? Let us know in the comment below.

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Snowball or Avalanche, Which is Better?

Posted on by David

In our last post we discussed the snowball method of eliminating debt. This method prioritizes paying off your smallest debts first. Then once the smallest debt is eliminated, you take what you were paying on that debt and add it to the payment of your next smallest debt. It is referred to as the snowball method because, like a snowball rolling down a hill becomes bigger, the amount that you pay towards your debts become larger with each eliminated loan.

One of the biggest proponents of the debt snowball is author and financial consultant Dave Ramsey. According to Ramsey, “When you pay off that smallest debt first, you get a taste of victory. And that feeling of success is the momentum you need to tackle the next debt with a vengeance.” The snowball method works because it gives you the hope that paying off debt is possible. And hope is very powerful tool.

Debt Snowball vs. Debt Avalanche

Last post we discussed the criticisms of the snowball method. Because the snowball method has you paying off your smallest debts first regardless of interest rates, you will end up paying more in interest using the snowball method than if you were to use the avalanche method of prioritizing debts by interest rates. Critics will say that the snowball method is fundamentally flawed in this way.

So let’s do an example to see which is better: the debt snowball method or debt avalanche method. Let’s run the numbers to see if (and by how much) the debt avalanche saves you in interest paid and total time to pay back your debt. I’d never seen a breakdown like this before, and I was curious. Let the math begin!

Using Unbury.me I created a debt budget. I decided to simulate a young couple who recently graduated from college (because I have experience with that). The family has two car loans, 2 student loans and some credit card debt. I selected the interest rates and principle amounts specifically so that each method would prioritize paying off the loans in different orders. The calculator has the option to choose between each payment type and also the option to increase your monthly payment. In this case the minimum was $1,775, but you could allocate more money to pay off your debt quicker. I chose to leave it at the minimum because increasing it didn’t affect which option was better.

5 loans total $65,000
Pick your poison: debt snowball or avalanche.

Let’s Crunch Some Numbers

These loans come out be a total of $65,000 worth of debt which is a pretty hefty sum, but even paying the minimum of $1,775/month it can be eliminated in just a few years. So which option is better?

Using the snowball method of paying off the loans with the lowest principle first, this hypothetical couple will have finished paying off their debt within 43 months. The amount of interest paid on this debt will be $11,555.21. Killing $65,000 of debt in under 4 years is pretty impressive. The reason this is so fast is because for each loan that is paid off all of the money you would normally put towards that loan can be lumped into your payments to the next loan. So how does this compare to the avalanche method?

debt snowball works
Using the debt snowball method the debt is paid off in 43 months

If we switch over to the avalanche method of prioritizing the highest interest loans, this hypothetical couple will be able to finish paying off their debt within 43 months. Exactly the same amount of time. Well that’s not exactly shouting a clear winner is it? What about interest paid? The avalanche method does pay less in interest over those 43 months. Using this method the couple pays a total of $10,985.44 in interest which is $569.77 less. That’s about $13 a month less.

While not nothing it’s not a smashing victory for the avalanche method. I’ll be honest, I really expected the difference to be a lot more drastic! After all the hate the snowball method receives for wasting your money, you’d think it would be a runaway victory for the avalanche. Seems less like an avalanche and more like a snowdrift to me.

debt avalanche works too
Using the debt avalanche method the debt is also paid off in 43 months

An Unclear Victory

So which one is better? That’s up to the individual to decide. On a purely math basis the debt avalanche is the option that ends up saving the most money. In this case the debt repayment dates were the same. I tried changing the different loan amounts to see if that would result in different repayment dates. It technically did, but I had to make drastic changes to create any big difference. For example if I up the credit card debt (18% APR) from $9,000 to $40,000 (huge) the avalanche method still only pays off the debt 4 months quicker than the snowball method.

[The Debt avalanche method] might sound like smart math. Here’s why it’s not: Debt isn’t a math problem. It’s a behavior problem.

Dave Ramsey

So if you’re a purely mathematical person who doesn’t insert emotion into their rationale, the debt avalanche may be your better option. But if you operate purely based on math, you probably aren’t in debt. Or at least not that much. That’s probably why Dave Ramsey says that “Debt isn’t a math problem. It’s a behavior problem.” The reason people get into debt they can’t control is because they aren’t being objective and rational.

This is why the snowball method has worked for so many people. Because paying off those small debts first give you that feeling of accomplishment that gives you the motivation to pursue your larger debts and as Dave said, “Motivation is the key to becoming debt-free, not math.”

Conclusion

We have friends who have used the snowball method with a lot of success, and the story is the same every time. “We didn’t think we could do it. Our debt was so daunting! And then bam! First debt completely gone. It was like we could suddenly breathe again.” Don’t underestimate how much of a head game paying off debt can be. You can choose whatever debt repayment method you like, but whatever you choose, start now! The sooner you start, the sooner you can be to a more Financially Independent place. And remember, it’s OK for it to be a slow burn.

What do you think? Were you surprised by my results? Do you see any flaws in my math? Impossible, I know! Let us know in the comments below.

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Dave Ramsey and the Debt Snowball

Posted on by David

When it comes to eliminating debt there is usually one name comes to the forefront of everyone’s minds: Dave Ramsey. Ramsey is a radio host, TV host, author, and champion of the debt snowball. This method prioritizes paying off your debts from smallest to largest. Once the smallest debt is eliminated, you take what you were paying on that debt and add it to the payment of your next smallest debt. This is referred to as the snowball method because, like a snowball rolling down a hill becomes bigger, the amount that you pay towards your debts become larger with each eliminated loan.

Ramsey is no stranger to the kind of debt or financial hardship that he counsels people through. In college he began investing in and selling real estate and by 26 had amassed a $4 million portfolio. However he had become over-leveraged and by the next year he declared bankruptcy. Eventually, after recovering from his bankruptcy he began offering financial advice to couples at his church and that turned into a financial counseling business that has helped 6 million families get out of debt. And one of the biggest things he recommends, like we already mentioned, is the snowball method.

Why the Snowball Method?

Advocates of the snowball method argue that the reason it works is because paying off the smallest (easiest) debt first gives you that first victory quicker. Claiming that first victory quickly is exciting and gives you the motivation to keep working at paying off your debt. After the first debt is payed off, all the money that you were paying towards that debt can be added towards paying off the next smallest debt. That extra amount then helps you pay off the next debt quickly as well, giving you more excitement and motivation to conquer your debt.

Being deep in debt, on top of the financial burden and pressure it puts you under, can lead to a real sense of hopelessness. Oftentimes, paying the minimum towards debt can land you deeper in debt than you were before that monthly payment. The whole situation feels a little like drowning. The snowball method works because it gives you the hope that paying off debt is possible. And that hope can be just as important to conquering debt as reason and logic.

Snowballs eliminate debt... and maybe your friends

Criticisms of the Snowball Method

Critics of the snowball method counter with the fact that prioritizing your debts by principle amount rather than interest rate means that you’ll end up paying more in interest than you would if you tackled the debt with the highest interest rate first. That’s true. This is sometimes referred to as the avalanche method (I think just because it follows the same snow motif). Paying off your debts with the highest interest rates first will minimize the total amount payed in interest.

Since your smallest debts may not have the highest interest rates, you will end up paying more in interest using the snowball method than if you were to use the avalanche method so logically the avalanche method is a better option. Because of this I was firmly in the debt avalanche camp. But remember what I said above: “Hope can be just as important to conquering debt as reason and logic.” Debt is illogical. Most people get into debt by trying to keep up with the Joneses. There are a few good reasons to get into debt, like a buying a house, but most of the time getting into debt is illogical. Because of that it’s very difficult to logic your way out of debt.

Debt isn’t a math problem. It’s a behavior problem.

Dave Ramsey

Debt Snowball vs. Debt Avalanche

So which is better, the snowball or the avalanche method? Well if you like instant gratification and prefer to see results quickly the snowball method may be right for you. It allows you to quickly see initial victories and that momentum helps to motivate you to clinch those next victories. Perhaps a debt-repayment plan with a longer outlook for eliminating the first loan may cause you to lose motivation and give up on getting out of debt.

If you are the kind of person who is able to formulate a plan and stick to that plan for the long run, the avalanche method may be the better option for you. If you’re the kind of person who goes into your undergraduate fully expecting to take 12 years to finally finish your PH.D then you can probably take advantage of the avalanche method and thrive.

The FIRE community has been known for its math-based logical approach to eliminating debt and reaching financial independence so it’s probably safe to say that the debt avalanche approach is a better option for most readers here. But then again the kind of people who create a plan and stick to it unflinchingly for years on end aren’t usually the kind of people who frivolously get into debt. So that may be a moot point.

According to Ramsey’s website:

The debt avalanche and debt snowball have a similar goal: to help you become debt-free. But the debt snowball gives you motivation, and motivation is the secret sauce that gets you debt-free faster! When you pay off that smallest debt first, you get a taste of victory. And that feeling of success is the momentum you need to tackle the next debt with a vengeance. 

With the debt avalanche, you won’t get a feeling of accomplishment for a long time. You could lose steam and give up long before you even pay off the first debt! Sure, it might make sense mathematically to begin with the debt that has the highest interest rate, but—let’s get real—if we were focused on math, we wouldn’t be in debt in the first place.
Most fiscally responsible credit card ever

Conclusion

I went into this study favoring the debt avalanche method of paying off the highest interest loans first. And in my mind I still prefer it. For example the best investment you can make is paying off credit card debt. But I’ve never been in debt (other than a mortgage) so I guess this debate really isn’t for me.

But for people who feel crushed beneath the weight of their debt maybe the snowball method is the best way. I think I’m coming around to this side of the argument. Little victories early on in the process can make a marathon feel more like a sprint. And they can make it feel less daunting. If you are the kind of person who can stick to a plan by looking years into the future, the debt avalanche method is probably better, but for most people in a lot of debt the snowball method has real potential. Because for most people debt isn’t a math problem. It’s a behavior problem.

I our next post we’ll simulate a family’s debt with several different loans at different interest rates and calculate which option is better.

What do you think? Have you worked your way out of debt? How did you tackle it? Let us know in the comments below!