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.
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.
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 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!