Dollar Cost Averaging

When most people are ready to start investing, they have no idea how to actually deploy their capital into stocks.  The most frequent questions I get asked are should I wait for the market to pullback or should I just jump in now?  How and when you invest in the stock market can make a big difference in your rate of return. 

Any professional investor will tell you that timing the market is nearly impossible.  So how can you take timing out of the equation?  One of the most simple and effective approaches is to Dollar Cost Average.  It is a great idea in theory and in practice most of the time.  Dollar Cost Averaging into an index would mean to buy a fixed dollar amount worth of shares at fixed intervals.  For example, at the first of every month John buys $1,000 of shares of an S&P500 index fund.  If the price of the index fund is $20.00 then he has bought 50 shares.  The next month the share price of the index fund has appreciated to $25.00, so his $1,000 buys 40 shares.  As you can see this approach allows the investor to buy more shares when the price is lower and less shares when the price is higher.  This is supposed to decrease your average entry price.  Using this example John now has 90 shares with an average entry price of $22.22.  If he had bought equal amounts of shares instead of equal dollar amounts he would have an average entry price of $22.50.  Over a long period of time you can accumulate nice positions with this method, and you will not have had to worry about timing the market per say. 

This can be a powerful approach if the market is behaving, but what if the market just keeps rising and you could have invested all of it at a lower price to begin with?  The dollar cost average method really does not account for the investor with a lump sum to invest to begin with.  In fact, if one has a lump sum to invest already then I would not recommend the dollar cost average approach because it would involve you holding money that yields no return.  Instead, one can either invest it in different stocks all at once, or one can enter into partial positions and sell puts to gain entry at a lower price with the remaining capital.  These two strategies allow the investor to immediately gain yield on their money from dividends and returns or put premiums. 

Another argument against the dollar cost average method is that it “tricks” investors to build up a larger portfolio than they would have otherwise done if they had invested a lump sum all at once.  It is a secure and safe feeling to invest small amounts over time rather than large amounts all at once.  This argument is absolutely ridiculous to me.  For one it implies that having a larger portfolio is a bad thing.  How is this a bad thing?  If the investor is in it for the long term then he or she was not using money that would be needed in the short term, so the argument that they will need the money they invested is invalid in my opinion.  I have heard several people in my lifetime say that having too much money in a portfolio is a bad thing, but to this day I don’t know what they mean by it.  I suppose those people are either content with their savings and investments, or they are just very risk averse people like my friend who loves bonds.

The dollar cost averaging method is a very simple and systematic way to take the market timing and second guessing yourself out of the equation when investing.  It can be very powerful if you are investing small amounts over a long period of time, but if I had a lump sum once or twice a year then I would rather go with entry into partial positions and selling puts against the rest of the capital.  These are just some approaches that I have used, and both have their drawbacks.  However, all strategies have drawbacks.  There are many ways to invest money quickly or over a long period of time!  I encourage you to read about them; some strategies are very intricate and fascinating!

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