If you pay into your employer’s pension plan or have access to a stock purchase program, you probably use dollar-cost averaging or a periodic investment strategy without even realizing it. Each time the market or the stock in question drops and you make a contribution, you find yourself buying a little more. The reverse is also true. In the long run, it’s a strategy that pays off and is much less stressful, a rare thing when it comes to investing.
Whether or not you have access to these types of programs through your employer, there’s nothing stopping you from implementing such a strategy on your own. Sure, it takes a little more effort on your part, but it’s worth it. So here are five ideas to help you get the most out of Dollar-Cost Averaging:
1. Start as soon as possible
When it comes to investing, time is your friend. Here is an example that illustrates the difference between two individuals who start investing. Rachel starts when she’s 25 years old, Simon begins at 35.
- She starts saving at age 25
- She invests $6,000/year ($500/month)
- She saves for 10 years, until age 34, then stops completely
- Total saved = $60,000
- Annual compounded return of 8% throughout her life
- Retirement at age 65
Total at retirement = $1,000,000
- He starts saving at age 35
- He invests $6,000/year ($500/month)
- He saves for 30 years, until age 64.
- Total saved = $180,000
- Annual compounded return of 8% throughout his life
- Retirement at age 65
Total at retirement = $800,000
By starting 10 years earlier, Rachel will have more money than Simon when they retire, even though she saved three times less than he did ($60,000 vs. $180,000). This is the power of compound interest!
2. Pay yourself first
Typically, your expenses over your lifetime are likely to vary more than your income, so make sure your first expense is… yourself! Saving is paying yourself. Set aside a certain percentage of your income for savings, and make sure to increase the amounts you save as your income grows (which, hopefully, it will). Depending on your personal goals, you should save at least 15% to 20% of your income each year. If this is too much for your budget, an idea would be to start with a lower percentage and increase it by 1% each year until you reach 15%.
3. Stick to your original plan
If you plan on investing over a long period of time (at least 10 years), chances are you will experience your share of worries, euphoria, crashes, bubbles, and so on. Year after year, over the last century, stock markets have climbed walls of worry. We’ve seen it before and we’ll see it again. So make sure you stick to your original plan and don’t try to overthink every contribution you make. For some investments, your timing will be perfect. For others, not so much. But on average, you’ll get a reasonable return. Solid, long-term returns don’t depend on when you enter the market, but rather on your discipline!
4. If you have a lump sum to invest, that works too!
A lump sum is simply a large amount of money to invest all at once. People tend to have a lump sum when they sell their business or home, or when they receive an inheritance, for instance. Dollar-Cost Averaging or a periodic investment strategy can absolutely be used in this case, but here are some numbers you should consider.
We looked at each 3-, 6-, 12-, 24-, and 36-month period between 1928 and 2020. In other words, we made more than 1,000 observations, and we asked ourselves: what would have been the best option for an individual who had $120,000 to invest? Would it have been better to invest it all at once or would it have been better to divide it into equal amounts and invest it periodically over time? Below are the results of this research on the S&P 500:
$120,000 invested periodically vs. invested all at once (lump sum)
|Number of months selected for investing||Average return on the periodic investment for the selected period||Average return on the lump sum investment for the selected period||Most cost-effective strategy||% of time a lump sum investment would have been favorable|
|3 months = $40,000 each month||1.2%||2.8%||Lump sum||67%|
|6 months = $20,000 each month||2.4%||5.5%||Lump sum||69%|
|12 months = $10,000 each month||5.1%||11.3%||Lump sum||72%|
|24 months = $5,000 each month||10.9%||23.5%||Lump sum||79%|
|36 months = $3,333 each month||17.0%||36.9%||Lump sum||81%|
As you can see from the above table, the individual would have been better off investing all at once rather than periodically in installments, regardless of the number of months chosen. For example, $120,000 invested all at once would have generated an average return of 2.8% over a period of three months, whereas investing $40,000 per month for three consecutive months would have generated an average return of 1.2%. At the end of three months, the individual would have had 1.6% more money in his pocket. And in this case, a lump sum investment would have been the best strategy 67% or two times out of three.
This table also shows that the longer the period chosen to invest, the less rewarding a periodic investment is. The reason for that is quite simple: the market goes up more often than it goes down.
5. Choose a strategy that’s a good fit for you
Investing isn’t just about numbers. There’s a lot of emotion involved, and each individual needs to think about the best way to grow his or her investments. Choosing to invest a lump sum also means taking the risk that the market will drop next month. Think about what would have happened had you started investing in February 2020. However, as in the past, after a rough period, the market has risen higher than it was before the crisis. Both strategies explained in this article are appropriate and should be considered while taking your personality into account. If you have money to invest, choosing between investing the full amount now, over three months or six months, or even a year, is something you should think about.