What Dollar Cost Averaging Means for Your Financial Plan
Being a CERTIFIED FINANCIAL PLANNERTM, I learn all sorts of interesting facts and tidbits about finance that may not be known to everyone. I also have a lovely opportunity to meet all kinds of interesting people from various walks of life. When I meet these people, I love to learn all about their job(s) and how it's done. I'd like to think that most people are similar in my love for learning. That's one reason that I'm so passionate and dedicated about bringing you real information that can positively impact you and your family through mediums like this blog!
Bringing you information that's pertinent to your life and your financial plan, I feel it, is a part of my job. Some of my focus as a financial planner are College Planning and Student Loan Advising after-all, so I do feel strongly that education is essential and invaluable. I've gone on this long rant about education and making information about financial planning accessible because today, I'd like to focus on a subject and strategy that often goes overlooked but is often used by investors and money managers. The strategy I'm speaking of is called Dollar Cost Averaging, and if you're involved in any part of the investing process (from funding to managing), this subject needs to be on your radar.
Before I talk specifically about Dollar Cost Averaging, what it is, and how it works, I'd like to address something that's somewhat of an elephant in the room. Learning and educating (especially self-educating) about finance can be daunting; kudos to you for taking the time to better yourself through learning. However, while something like Dollar Cost Averaging does sound complicated, challenging, and out of reach, it's really not as daunting a subject as it appears. In fact, Dollar Cost Averaging is something that's extremely basic, and many people use this strategy without even realizing they're doing so. What they often don't understand, however, are the underlying benefits of utilizing Dollar Cost Averaging. (Rant Over)
So, again, what is Dollar Cost Averaging? Dollar Cost Averaging is the strategy of investing consistent and incremental amounts of money in the same share over time. That's precisely what it is, plain and simple. So, we're done, right? Of course, we aren't done, silly! Though that's a reasonable definition of what Dollar Cost Averaging is, it might not make the most sense, so let's approach it from another direction.
If you absolutely hit the million-dollar jackpot, what would you do with it? Many things come to mind for most people, but one of the most common answers to this question that I hear is "INVEST"! Money makes money, so you'd want to invest all million dollars immediately, right? Well, not exactly. There's a fundamental issue with investing money into the market, and that's a lack of ability to look into the future. AKA, we know what the market did yesterday, we know what it's doing today, but we can only predict what it will be doing tomorrow. This lack of knowledge creates an issue with investing - we don't know that we're getting the best "bang for our buck" when we're investing in shares.
Using Dollar Cost Averaging, we take away some of the risks of overpaying for shares. By investing the same amount of money consistently and regularly, we're minimizing risk by distributing purchasing over a more extended amount of time. See, when we use Dollar Cost Averaging, we're spending the same amount of money every week, bi-weekly, or month. Because cost fluctuates, that means each period we invest, we'll purchase a different amount of shares. One crucial tenet of Dollar Cost Averaging is ignoring what is happening in the market and sticking to our plan regardless.
Last week in my article, Why Dividend Reinvestment can be An Important Part of Your Financial Plan, I talked about the benefits of reinvesting dividends. As a quick recap, reinvesting dividends means taking the dividends (or returns) and reinvesting them back into the same investment. By reinvesting your dividends, you're taking advantage of something called compound interest. Every time you reinvest your dividends, it means that your next dividend payout will be higher. This process snowballs and creates a lot of money out of what can start off from a meager investment.
The reason I bring up Dividend Reinvestment in this article about Dollar Cost Averaging is not only because the two work well in coalition with each other, but because when broken down, the principles behind their effectiveness are essentially the same! Because of terminologies and a few functional discrepancies, it can be difficult to understand, how similar the principles behind Dollar Cost Averaging and Dividend Reinvestment are.
Dividends are paid out on a regular and consistent basis, usually quarterly (four times per financial year). By reinvesting the money you earn from your dividends instead of pocketing it, you're participating in a form of Dollar Cost Averaging. You're (re)investing a consistent amount of money (your dividend) over a consistent period (quarterly or otherwise). Though your dividend's exact dollar amount may change, you're consistently reinvesting the amount paid to you. Doing this while simultaneously receiving the added benefit of incentive programs, like DRIPs (Dividend Reinvestment Plans), is making the absolute most out of your money while lowering the average cost of how much you're spending per share over time. Similar to Dollar Cost Averaging, by reducing your average cost per share, you're also minimizing your risk and maximizing the likelihood of your potential return on investment.
When discussing the similarities surrounding Dollar Cost Averaging and Dividend Reinvestment, people can often get hung up on the fact that the exact dollar amount of a dividend may vary or be confused by the time consistency of dividend payouts. If you're having trouble understanding how Dividend Reinvestment and Dollar Cost Averaging work so well together and operate using the same philosophy, I'd be happy to help you. Please feel free to contact me by giving me a call or reaching out through our website.
Varying Asset Prices Can Equal A Lower (Average) Cost
When we're using Dollar Cost Averaging, we're basically attempting to mitigate our risk of over-paying. Over-paying can be a real pain when you're investing for a few reasons. For starters, you're just not getting the best deal you can get, and we all know that's not a good feeling. When it comes to investing, not getting a great deal isn't only not a good feeling, it can end up COSTING you money if what you're buying into doesn't perform. That's a risk, and if you're investing a ton of money lump-sum, you're truly susceptible to that risk. On the other hand, Dollar Cost Averaging mitigates that risk over a consistent and longer period of time.
Wait, but doesn't buying, no matter the market, mean that I'll over pay for my shares? It does, but it also means that you'll underpay for them too. Because we can never accurately know in the present if prices are too high or not, we're at risk of over-paying every single time we invest. What dollar cost averaging does is ensure that you're not over-paying for all of your investment by spreading it out when you buy.
Why Not Just Time the Market?
Timing the market is a dangerous game. Like I said, every time that we invest, there's a risk that we're over-paying. Suppose you have one hundred dollars to invest, and you purchase one share for one hundred dollars. Now, suppose that the next month, when you have no money to invest because you spent all of it on that one share, the price of those shares drop to twenty dollars a share. While you shouldn't be losing money in the long-term because you're a good long-term investor, that means you're missing out on the opportunity to purchase those same shares at a steep discount.
Now, let's consider another scenario. You have ten thousand dollars to invest total, and you decide you work with your CERTIFIED FINANCIAL PLANNER™ to come up with a plan of investing over the time frame in the example above. The first month the price of a share is one hundred dollars; the next month, it's seventy dollars, the third is ninety dollars, the fourth is eighty dollars, and the fifth is seventy dollars, and so forth. That means that with the same money over a longer period, instead of purchasing one share one time for one hundred dollars, you've stuck with your (incredibly volatile) investment through thick and thin and spent the same amount of money on two and a half shares. Now, this is an example using imaginary numbers. Still, you can see that over time, the average of your purchases could be significantly discounted.
Is Automation a Smart Way to Go About Investing With Dollar Cost Averaging?
At the risk of being too blunt, most people's issue with investing is that they get in the way of their own potential. A common newcomer's mistake is that when the market is down, they're overcome with panic and feel the need to immediately pull all of their money out of the market. This is not a good strategy. If you pull out all of your money when the market dips, you're ensuring that you'll experience a loss or your investment will not live up to its full potential.
The philosophy of Dollar Cost Averaging partially alleviates this bad habit. Monthly, weekly, or bi-weekly (or however else you prefer to schedule), you invest a specific dollar amount like clockwork. You don't micro-manage your funds/account; you just continue. Being in that mindset will take away a portion of the temptation to pull all of your money out when the market dips, as it regularly does. Unfortunately, the temptation is still there to pull out our money, but we can further dampen that temptation through automation! With automation, your money is invested automatically depending on your schedule or trigger event - like getting a paycheck. This allows your money to work for you while focusing on important things, like your job, friends, and family.
Automation, while incredibly helpful, can be difficult. I highly recommend talking to and working with your financial planning professional to set up an intelligent plan and have him or her help you with the automation process.
A CERTIFIED FINANCIAL PLANNER™ Can Create a Comprehensive Financial Plan To Help You Take Advantage of Dollar Cost Averaging
Dollar Cost Averaging, Dividend Reinvestment, and Financial Automation aren't incredibly complex concepts when they're broken down into understandable bits. Anyone can understand why they'd want to mitigate risk over time and maximize the chances of their investments succeeding. Still, I know that at times financial jargon can be overwhelming and confusing to people who don't deal with it on a day to day basis. People like me are here to help bridge gaps. I connect people with ideas that will help them succeed. I help them understand how principles work together and relate to one another. Most importantly, I bridge the gap between where people are in their financial life and where they'd like to be. By connecting all of these ideas, people, and principles, I'm doing a small part in helping people and their families become educated and work their way towards financial success.
If you have questions or concerns about Dollar Cost Averaging, Dividend Reinvestment, or automation, please give me a call. As a CERTIFIED FINANCIAL PLANNER™, I work with people to help create custom financial plans to meet their needs and their families' circumstances. I can work with you to help you understand all of the principles and how they will positively impact your situation. Visit our Client Service Experience Page to see how we can help!
Until next time, this is Melissa Making Cents.
Melissa Anne Cox CERTIFIED FINANCIAL PLANNER™ is also a College Planning and Student Loan Advisor and a Financial Coach in Dallas, Texas.