Dollar cost averaging is the act of consistently investing in a particularly security over a set interval of time. Most like to invest every two weeks or every month since that’s when most get paychecks. For example, let’s say you’ve got $2,000 left a month after you contribute to your 401k and pay your basic living expenses. You invest $1,000 every single month into the S&P 500 ETF, SPY, regardless of whether it’s reaching record highs or going into the crapper. That’s dollar cost averaging.
The great thing about dollar cost averaging is that you don’t have to think too much. All you have to do is not forget to invest, and eventually your financial nut will grow so large you’ll achieve make it rain status. Growing your wealth is all about practicing good financial habits that last over the long run. Sticking with a system of saving and investing will do way more than trying to uncover than unicorn stock for most.
At some point in your life you will either have a financial windfall (year-end bonus, inheritance, gift). There might also be violent corrections in the stock market as you’ll see in a chart below. Given the stock market trajectory over the long-term is up and to the right, you should come up with a framework on how to best take advantage of opportunities in a methodical way.
Here’s how I think about how much to dollar cost average. It’s kind of an oxymoron to “figure out” how much to dollar cost average, but hear me out. Hopefully my framework will help you better deploy your cash.
FIGURING OUT HOW MUCH MORE TO DOLLAR COST AVERAGE
Hopefully most of you agree with the logical proposal of FS-DAIR, my debt pay down or invest ratio that says to use your highest interest rate debt to determine the percentage of disposable income allocated towards paying down said debt. e.g. 6% student loan debt = 60% of disposable income to pay down debt, 40% to invest. The percentage split doesn’t have to be exact. FS-DAIR simply provides a guideline.
Before initiating my aggressive early mortgage pay off strategy, I was investing around 65% of all disposable income into the stock market because my highest debt interest rate is currently a 3.375% rental mortgage. For illustrative purposes, let’s say my monthly after-tax disposable income after basic living expenses is $10,000. Without fail, I will invest $6,500 a month into a structured note or an index ETF. $3,500 would go towards paying down debt.
But the reality is that I can invest $0 – $10,000 a month in the market so long as my income keeps flowing in (build multiple income streams!). Furthermore, I’ve always got some cash sitting on the sidelines waiting to be deployed for investments, operating needs, or emergencies.
The first step to deciding on how much to invest beyond your average investment amount is to research what is the average daily change in the S&P 500. See the chart below by Bespoke Group.
We’ve gone from a crazy 3-4% average daily change swing during the recession to a relatively mild +/- 0.76% by July 2011. Through 2014 the volatility has continued to remain relatively low. To smooth things out, I’ve drawn a line at a +/- 1% change. During times of low volatility, when there is high volatility the changes are more significant.
My current bogey for when I’ll be investing more than my normal 60%-70% a month is when the S&P 500 corrects by more than 1% that day or since the last time I dollar cost averaged. For example, let’s say the return on the S&P 500 is -1.5% from two weeks ago since I last invested $6,500, I’ll be looking to invest $6,501-$10,000 that month at the expense of paying down debt.
Exactly how much one should invest is a judgement call that depends on liquidity beyond the bi-weekly or monthly cash flow, and one’s existing net worth allocation makeup. The worse your target index performs beyond your bogey, the more you should consider investing. For example, if your bogey is -1% and the S&P 500 declines by 1.8% since your last investment, consider allocating 80% of the money that would have gone to pay down debt towards your investment. In this case, I’ll take 80% of $3,500 and invest it instead.
As of now, we’ve been talking about when to invest more in the stock market. But we can also use the same strategy in reverse. For example, let’s say the stock market is up 1.5% since you last invested, or 50% higher than your bogey. You could conceivably reduce your dollar cost average by 50% $3,750 in my case (from $6,500), and use the other $6,250 to pay down principal instead. Buy low, sell high right?
COUNTING CARDS ANALOGY
For any of you who play blackjack, the strategy is similar to pressing your bets when the odds are in your favor. Let’s say you are playing single deck blackjack. The Hi-Lo system subtracts one for each dealt ten, Jack, Queen, King or Ace, and adds one for any value 2-6. Values 7-9 are assigned a value of zero and therefore do not affect the count. The idea is that high cards (especially aces and 10s) benefit the player more than the dealer, while the low cards, (especially 4s, 5s, and 6s) help the dealer while hurting the player.
When the count is super high (when a lot of low cards have been dealt, meaning the probability of high cards being dealt has increased), you are encouraged to bet more to increase your total payout..
Obviously, nothing is a guarantee. I’m just trying to give you an analogy of how professional gamblers utilize a system to stay disciplined and try to increase their odds. Unlike gambling, investing in the stock market is usually not a zero sum game. You might lose 20% on your investment, but you seldom lose 100% of your investment like in gambling, unless you go on margin and get wiped out.
Here is a great chart that shows the biggest one day gains and losses in the S&P 500 as well.
COMPARE PERFORMANCE TO RISK-FREE RATES
It’s always good to compare market movements to existing risk-free rates of return. I like to look at the latest 5-year average CD interest rate (2.2% currently) and the 10-year government bond yield (~2.45%) as benchmarks. Buying these instruments will guarantee you a 2.2%-2.5% return per annum and all your principal back if you hold until maturity.
If the markets are correcting by similar levels to the interest rate return, and if you are bullish on the stock market over the medium-to-long term, then all the more reason to increase your dollar cost average contribution during this time period. Of course, nobody knows where exactly the market is going, which is why we are consistently diversified between stocks and bonds.
I personally like to look at indexes or securities that have corrected by at least the guaranteed 10-year government bond yield AND provides a dividend yield of at least the 10-year government bond yield. I feel like I’m getting a deal, despite the reasons for a decline in the first place. The large-cap dividend ETF, DVY is a good example of what I invest in. It has a dividend yield of 3.63%, or ~1.1% higher than the current 10-year yield.
DON’T OVER THINK THINGS
The purpose of dollar cost averaging is to make investing easy for the average person who is not all caught up in the stock market. Taking the maximum 401k contribution limit of $17,500 and investing $729 every two weeks into whatever index fund you like is the most common way to dollar cost average. I believe consistently investing over time is more than 80% of the battle to achieving great wealth. It’s how everybody can get to $1 million dollars in their 401k by age 60.
Figure out how much you can comfortably invest each paycheck and get going. You might not agree with a +/- 1% bogey for when to contribute less or more than average. That’s OK. Figure out your own bogey. Then track your net worth and your portfolios online for free with Personal Capital. I ran my portfolio through their 401k Fee Analyzer and found that I was paying $1,750 in portfolio fees I had no idea I was paying! I would have paid over $90,000 in fees over 20 years if I didn’t get rid of my expensive actively managed mutual funds that were charging 0.75%-1.3% active management fees.
RECOMMENDATIONS TO BUILD WEALTH
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In the long run, it is very hard to outperform any index, therefore, the key is to pay the lowest fees possible while being invested in the market. Wealthfront charges $0 in fees for the first $15,000 if you sign up via my link and only 0.25% for any money over $10,000. You don’t even have to fund your account to see the various ETF portfolios they’ll build for you based off your risk-tolerance. Invest your idle money cheaply, instead of letting it lose purchasing power due to inflation.
About the Author: Sam began investing his own money ever since he opened an online brokerage account online in 1995. Sam loved investing so much that he decided to make a career out of investing by spending the next 13 years after college working at Goldman Sachs and Credit Suisse Group. During this time, Sam received his MBA from UC Berkeley with a focus on finance and real estate. He also became Series 7 and Series 63 registered. In 2012, Sam was able to retire at the age of 34 largely due to his investments that now generate roughly $175,000 a year in passive income. He spends time playing tennis, hanging out with family, consulting for leading fintech companies, and writing online to help others achieve financial freedom.
Updated for 2017 and beyond.