Latest posts by Wanderer (see all)
- Reader Case: Can this 24-year-old from DC Retire Early? - January 18, 2019
- Our 2018 Finances Part 2 - January 14, 2019
- Reader Case: Does FIRE Math Apply to the Elderly? - December 21, 2018
Over the past few days, we’ve been getting questions via email from people who have a bunch of money saved (yes, they DO exist), want to start investing but are concerned that the market’s too frothy (the Dow JUST hit a new all-time high last week), or Brexit/Donald Trump is just around the corner, and they’re not sure that now is the right time to enter the market.
And believe me, this is not a new debate. We went through this exact same thing when we were starting out. When it comes to picking an entry point in the stock market, the joke is that there are only two thoughts that investors have:
- Markets are going up too fast. I’d better wait.
- Markets are crashing. I’d better wait.
Heck, when we, in our infinite wisdom, decided to enter the market, we managed to pick the single worst possible time, September 2008, right on the eve of a the worst financial crisis and stock market crash we’re going to see in our lifetime. And yet we still managed to come out unscathed. How?
Dollar Cost Averaging.
Basically, Dollar Cost Averaging (or DCA, as the cool kids call it) is the idea that instead of deploying all your cash in one go, you space out your buys over time. For example, if you have $100k, instead of just buying $100k of ETFs (in whatever portfolio allocation you’ve decided), you split up your $100k into $25k slices, and deploy it in 4 separate buys every quarter. This way, you wade into the water over time instead of jumping in all at once.
Now, Dollar Cost Averaging is often maligned in the media because statistically, it’s been better to dump all your money into the market in one lump-sum buy as soon as you can. And you can find article after article showing this. This entire argument, however, is really harmful to people trying to figure out how to invest their money. Why?
Let’s examine where these statistics are coming from.
Here’s a typical chart of the performance of the S&P 500, from 1995 to 2000.
Charts like this are easy to find, because as we’ve written about before, the Indexes have historically gone up. In fact, over 15-year periods, the S&P500 has never lost money, so you can always find time periods that look like this chart. In this scenario, the right thing to do is obviously deploy all your cash at the beginning when the line is low, and then just let that bet ride. If you were to spread out your buy orders so that you’re buying an equal amount every month over the first two years, you would obviously underperform the lump-sum investment.
That’s the typical argument for not using Dollar Cost Averaging. However, let’s see what happens when the market’s aren’t behaving quite so nicely.
Here is the S&P500 from the not-so-fun period of 2008-2013.
That’s the crash of 2008 plus the uneven and rocky recovery finally ending in 2013. In this scenario, dollar cost averaging over the first 2 years would have resulted in buying units right into the storm. How does that work out?
Huh? What? I’ve outperformed the market?
Yupperinos. The beauty of Dollar Cost Averaging is that when you do it in a flat (or crashing) market, you end up picking up more units at a lower price. And because you’ve picked up more units, when the recovery happens you end up participating in the upside more strongly than the downside.
In fact, the scenario of spreading out your buys into monthly purchases over two years pretty closely mirrors what we actually did. And we’ve claimed before that despite the fact that the markets didn’t recover until 2013, we regained all our money by 2009. You can actually see that happening in this chart. Because we re-balanced our assets and continued piling in more money from our pay-checks even as markets crashed, we were essentially Dollar Cost Averaging, and that’s why we didn’t lose money in the Great Financial Crisis.
That being said, the whole debate about Dollar Cost Averaging vs Lump Sum Investing is stupid and irrelevant. For a typical person trying to save/invest in early retirement, it always makes sense to Dollar Cost Average.
Why? Well two reasons.
First, the Lump Sum argument has you being handed $100k all at once. In what real-life scenario does this actually happen? Normal people who don’t have the last name Kardashian don’t get randomly handed $100k checks. I didn’t. We worked normal jobs and got paid gradually over the year, usually in 2 week increments. So you naturally have to Dollar Cost Average anyway.
And secondly, even if you did get handed $100k and wanted to invest in a lump sum, think about how intimidating that would be. If you’re doing something for the first time, whether it’s investing, or scuba diving, or asking someone out on a date, if you’ve never done it before it’s terrifying. What typically happens in this scenario is the would-be investor starts reading articles, listening to financial pundits, staring at stock market charts and thinks “Oh God, is this the right time? What if it crashes? But what if it goes up and I miss out? Gaaaah!” And then they freak out and do nothing. This is known as analysis paralysis, and if you’ve ever procrastinated in doing something risky, you know what this feels like. It ain’t fun.
But what if our investor actually does close his eyes and hit the buy button? What then? They’re going to stare at their portfolio all day and freak out at every little movement. If it actually goes down (and it always eventually goes down), they’re going to think “Crap crap crap, I’m such an idiot! This was a terrible idea!” and then they’ll panic-sell and never touch investing ever again.
Dollar Cost Averaging fixes all of this. By wading gradually into the water and investing periodically, no matter what happens in the market, the investor will always feel like they’re in control. If the markets go down, they’ll think “Oh good. I can pick up more units at a cheaper price. I’m so smart.” And if it goes up, they’ll think “Oh good. I picked up some units before and now I’m making money. I’m so smart.”
See how different that experience is?
So ignore all the studies and ignore all the articles arguing over whether Dollar Cost Averaging is better than Lump Sum.
Always Dollar Cost Average. It’s the only way to invest without freaking out.
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