Updated: Feb 5, 2019
What the hell is that?! I understand what dollar means, I understand what cost means, and I understand what averaging means, but when you put them together, with the hyphens, in one word, it's like a different language altogether!!! Ugh I hate hyphens!
In this blog post I hope to clear the air on this somewhat scary term. With a really cool example and great video from Tony Robbins, I hope the reader leaves with more clarity about Dollar-Cost Averaging (DCA) and realizes that it is, in fact, a great tool for the long-term passive investor. I do want to bring up also, that like most things in life, there are pros and cons with DCA. I'll talk about all that in this blog post as well, and after reading the post I leave it up to you, the reader, to decide whether you implement this tool in your long-term investment strategy or not. Shall we?
I'll first start with a more technical definition that I got from Investopedia: Dollar-cost averaging (DCA) is an investment technique which involves buying a fixed dollar amount of a particular investment on a regular schedule, regardless of the share price. As a result of the approach, the investor ends up purchasing more shares when prices are low and fewer shares when prices are high.
You may look at your current lifestyle and realize you're already doing this. A lot of my corporate friends have a 401(k) from their employer that automatically deducts 10-15% from their monthly paycheck and automatically puts that money into a fund. With DCA, my corporate friends don't have to physically take 10% and put it into the fund. The whole process is automated and as a result, they don't care what's happening in the stock market. The EMOTIONS (Mainly STRESS) are taken out of the equation because, again, the process is automated, and over time they will have paid the average price for the asset. They don't have to time the market and try to get in when things are about to go up and worry when things go south.
When you combine the use of DCA with the power of compound interest you get some really amazing results in the long term.
Let's bring back our golf buddies, Micheal and Jim, from the previous blog post. (If you need a refresher on compound interest, feel free to check out the previous post)
If you look at the table below, (which is from the previous blog post: Compound Interest pt. 2) from just compound interest alone, Micheal and Jim played for about $13,000 at the 18th hole.
Now, let's say they play another round of 18 holes except now we add Dollar-Cost Averaging into the mix. Let's set the scene:
Micheal and Jim meet up again for another round of 18 holes at Micheals golf club. Jim initiates the conversation.
Jim: "Man, last time was amazing, Micheal! Thanks for the lesson on compound interest."
Micheal: "No problem man, anytime. How about we make things even more interesting this time around?"
Jim: "Are you serious? How could it get more interesting? Last time was pretty amazing."
Micheal: "I know, I know, compound interest right? But now lets spice it up with some Dollar-Cost Averaging."
Jim (smiling, curious): "Ok. Explain what you got in mind."
Micheal: "Ok! So, same premise as before. We'll start hole 1 at $0.10 and then double the value of each hole thereafter like we did the other day, except this time, in between each hole, as we walk up to the green, I'm going to add a $1 into the pot (DCA) and then we'll double the value, like we did the previous round. So for example, Hole 1 is $0.10. As we walk up to hole 2 I'll add $1 into the pot and then we'll double the value of the pot like we were doing before. So now hole 2 will be worth $2.20 ((1+0.10)x2). And like this we'll keep going. I'll add a dollar to the pot and then double the value of the hole, until we finish our round.
Jim: "Cool! Just remind me again, what was that word you used before? Dollar-Cost....
Micheal: "Dollar-Cost Averaging!"
Jim: "Right! So Dollar-Cost Averaging is that dollar you put into the pot as we walk up to each hole? Like a consistent, automated investment for every hole of the course."
Micheal: "Yup! That's it exactly! Shall we?"
Jim: "We shall."
The boys play their full round of golf and by the time they get to the 18th hole Jim is flabbergasted.
Jim: "Oh my god! In the previous round, when we got to the 18th hole it was worth about $13, 000! Now its worth..."
Micheal: "I know, man. That extra dollar I put into the pot made a huge difference in the long-run."
Jim: "Holy crap! That's what DCA and compound interest can get you, huh?
Jim: "If only more people knew..."
Micheal: "We'll get there Jim, we'll get there."
Micheal and Jim walk off into the sunset enjoying iced-cold Coronas.
So, how much did they end up playing for in the end? Check out the table below:
Yup, that's right. The 18th hole was worth $275,000. Thats about 21x more money in the pot. It's the same time frame and same growth rate between each hole as before (100% growth rate), but the only difference is that we added the concept of DCA. When you combine the two simple principles of DCA and Compound interest you will hit the critical mass point sooner, than if you just took advantage of Compound Interest.
With just compound interest we hit the Critical Mass Point at about hole 12 (Check out the previous blog to learn about CMP), whereas when we combine DCA and Compound Interest we hit the critical mass point at hole 7 or 8. That's 4-5 holes sooner! That's why it's important to implement DCA into your financial practice. Get into the habit of setting aside 10-15% (or even just 5%) of your income a month that goes directly into a low cost index fund (I'll explain index funds in a future blog post. Dont worry!).
Now some of you might say, "Layman Investor, I'm not going to double my money every year by investing in the market. Thats impossible!" And you would be totally correct. The reason I am using these examples with these growth rates is simply to show you and help you to understand the concepts of DCA and compound interest. I am not guaranteeing you any specific rate of return because the truth of the matter is no one can do that. There are NO fortune tellers, although many will pretend to be. No one can tell what the future growth rate of the stock market will be (Not even experts like Warren Buffet, or Ray Dalio), but what we can say with great certainty, and I'll quote Jack Bogle here (Creator of Vanguard Index Funds): "In the long-run, stock returns depend almost entirely on the reality of the investment returns earned by our corporations. The perceptions of investors, reflected by the speculative returns, count for little. It is economics that control long-term equity returns; the impact of emotions, so dominant in the short-term, dissolves." *Mic-drop*
I'll be expanding more on this topic of speculation in a future blog post.
These two tools, Compound Interest and DCA, are vital to creating a long-term investment portfolio for the passive investor. I really hope the example above helps illuminate the power of combining both concepts together. They go together like Peanut Butter and Jelly, or Mario and Luigi, Frodo and Sam.
Cons of DCA:
Like anything in life, there are pros and cons and DCA is no different. Some people argue that because timing is so important in becoming a successful investor, that a DCA approach to investing can cause investors to miss out on the "right" time to invest in the market (the "right" time being as the market is trending upwards). That is true because with the DCA approach, you invest every month regardless of where the market is. And then over time you will pay the average price of the asset. But my counter-point to this "timing" argument is that for the beginner investor or layman investor, we don't have time to figure out when the "right" timing is. We have other full-time jobs and obligations keeping us from tracking the market on a daily basis. We don't have the time to "time" the market. Leave that to the active investors whose job it is to do that.
Another argument against Dollar-Cost Averaging is the "averaging" part. A DCA approach aims for the average price of an asset (stock, bond, etc.) which means we don't get above-average performance from our asset. We also don't get below-average performance. We get, as the name suggests, the average-performance of the asset over a long period of time. DCA is not a panacea for investing. We, even as layman investors, have to make smart decisions when picking which assets to invest in (Future Blog Post). You can't just Dollar-Cost average into a losing asset because then you will lose (Duh!). My counter-argument to this is that we, as mainstreet investors, should not be picking individual stocks in the first place. We don't have the knowledge or the time. What I am arguing (and so are the top investors of the world like Warren Buffet, Jack Bogle, Ray Dalio, Tony Robbins) is that we should be invested in the entire damn economy. We should be invested in America itself, not out of some kind of patriotism, but because we believe that in our lifetimes the country of America, the actual country, will not go extinct and that our economy will, over the long-term (despite future recessions and/or depressions), continue to grow and if we're invested in it, then we should grow as well. Check out this short video of Tony Robbins discussing dollar-cost averaging and investing in the American Economy. I'll also add this video into the "Videos" page.
Well there it is. I hope that explains the ins and outs of Dollar-Cost Averaging for the layman investor. And I hope it wasn't anything too complicated. I've tried to be as clear and in-depth with the topic as I could be. I hope that this blog post has inspired some people to start looking at other aspects of their life where they can see metaphors for Compound Interest and DCA at work. They are powerful tools for the layman investor.
Before signing off, I do want to reiterate an important point. I am simply sharing this information from an educational standpoint. I am not here to tell what you have to do with your money to make a buck. I am simply sharing with you the information, that I think is so valuable, that we can all benefit from. I am in no way promising a specific rate of return for the unknowable future. I am not a fortune teller. I simply want to help share the fundamentals that I've learned from reading content from some of the best investors in the world that you can use (or not) for your own personal financial goals. Thank you for reading and stay tuned for more exciting insights!