Dollar-cost averaging is the act of consistently investing in a particularly security over a set interval of time. Whether you know it or not, you are likely dollar-cost averaging every time you get a bi-weekly or monthly paycheck.
For example, at the beginning of the year, you may elect a fixed percentage of your pre-tax salary to go to various investments in your 401(k). That’s a form of dollar-cost averaging.
But what if you’ve got $2,000 left a month after you contribute to your 401k and pay your basic living expenses? You could invest an additional $1,000 every month into an S&P 500 ETF, regardless of whether it’s reaching record highs or going into the crapper. That’s dollar-cost averaging too.
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.
To do so, you make investing a certain amount or percentage of income automatic. Eventually your financial nut will grow so large you’ll achieve make it rain status.
But what if you consistently have excess cash flow after maxing out your tax-advantageous retirement accounts? You also realize that the key to retiring early is being able to amass a large enough passive income portfolio to pay for your living expenses.
In such a scenario, we must think about a more appropriate dollar-cost averaging strategy to build maximum wealth. Let’s think things through and lay out a foundation first.
A Better Dollar-Cost Averaging Strategy
My dollar-cost averaging strategy is to invest more than my normal amount whenever the S&P 500 corrects by more than 1%. I’ve tried to stick to this strategy for over 20 years.
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 a unicorn stock for most.
At some point in your life you may have a financial windfall (year-end bonus, inheritance, gift). Or, there might also be violent corrections in the stock market, like the one we experienced in March 2020 when the S&P 500 sold off by 30%.
Given the stock market trajectory over the long-term is up and to the right, we should come up with a framework on how to best take advantage of opportunities in a methodical way.
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.
Pay Down Debt Or Invest
Before you invest, you should always understand your opportunity cost. If you have debt, your opportunity cost is not making a guaranteed return equal to your debt interest rate.
Hopefully most of you agree with the logical proposal of FS-DAIR, my debt pay down or invest ratio framework.
FS-DAIR 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 one of my mortgage pay off strategies, I was investing around 65% of all disposable income into the stock market. My highest debt interest rate was a 3.5% 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 an equity ETF or a favorite real estate crowdfunding investment. $3,500 will go towards paying down debt.
But the reality is 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 decide how much to invest beyond your average investment amount is to understand what is the average daily percent change in the S&P 500. See the chart below by Bespoke Group.
Average Daily Percent Change In The S&P 500
The average daily percentage change in the S&P 500 since 2006 is +/- 0.76%. Therefore, 0.76% is the baseline where we should consider investing more money in stocks on down days.
We’ve gone from a crazy 3-4% average daily change swing during the recession to a relatively mild +/- 0.76% by July 2011. Volatility came back with a vengeance in 4Q2018 and in 1Q2020.
To smooth things out, I’ve drawn a line at a +/- 1% change. A 1% change is easier to remember than 0.76% change.
Therefore, my decision for when I’ll be investing more than my normal 60%-70% a month of cash flow into the S&P 500 is when the S&P 500 corrects by more than 1% that day. Alternatively, I will invest more when the S&P 500 has corrected by more than 1% since the last time I dollar cost averaged.
Here’s another great visual highlighting the historical S&P 500 volatility from 2009 – 2019. As you can see from the chart, the S&P 500 usually moves between -1% and +1%.
Example Of Better Dollar-Cost Averaging Strategy
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 up to an additional $3,500 ($10,000 – 6,500) that month instead of using the $3,5000 to pay down debt. Why? Because the S&P 500 declined by more than my dollar-cost average threshold of 1%.
Exactly how much more to dollar-cost average is a judgement call. It depends on your liquidity beyond the bi-weekly or monthly cash flow and your existing net worth allocation makeup.
The worse your target index performs beyond 1%, the more you should consider investing.
For example, let’s say your hurdle 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 debt towards your investment instead.
In this case, I’ll take 80% of the $3,500 I would have used to pay down debt and invest it. In other words, I will invest my usual $6,500 a month + $2,800 ($3,500 allocated to debt X 80%) for a total of $9,300. Only $700 out of the $10,000 will be used to pay down debt.
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.
Dollar-Cost Averaging To Invest Less
Let’s say the stock market is up 1.5% since you last invested. You’re nervous about the future. Or, you may have some liquidity needs. Therefore, you may want to invest less than your usual $6,500 a month cadence.
You could reduce your dollar cost average by 50% and use the savings to pay down debt instead. In this example, you could reduce the $6,500 allocated towards investing by 50%. The $3,250 would be saved or used to pay down more debt, in addition to the $3,500 already allocated towards debt pay down.
Counting Cards Analogy
My dollar cost averaging strategy is similar to counting cards to get an edge in blackjack. You want to press 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 guaranteed. Further, the stock market tends to go up in the long term. 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. Having a system you methodical follow is what will help you get rich and not leave a lot of cash uninvested over the years.
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 Investment Performance To A Risk-Free Rate
Another way to figure out when to invest more is to compare the 10-year bond yield to a market correction. For example, let’s say the 10-year bond yield is at 1.5% and the market corrects by more than 1.5%. That might be a signal for you to buy.
Another signal to dollar-cost average more is when your investment declines by more than the highest interest rate of your debt. For example, if the market declines by more than 3% and your mortgage rate is 3%, you can consider buying more than your normal cadence.
Of course, nobody knows where exactly the market is going. This is why we are consistently diversified between stocks and bonds.
I personally like to look at securities that have corrected by at least the guaranteed 10-year government bond yield AND that provide a dividend yield > 10-year government bond yield. I feel like I’m getting a deal, despite the reasons for a decline in the first place.
No Need To Over Think Things
The purpose of dollar-cost averaging is to make investing easier for the average person. Most of us have day jobs and have better things to do with our time. As a result, at the very minimum, we just max out our 401(k) and/or IRA and think that’s all we need to do.
We need to consistently dollar-cost average as much of our extra cash flow as possible into a taxable investment account. You can invest for principal appreciation, for dividends, o both.
If you don’t like building a taxable investment account, build a real estate portfolio instead to diversify beyond your tax-advantageous retirement accounts. Real estate is actually my favorite asset class to build wealth due to the utility and income it provides.
I believe consistently investing over time is more than 80% of the battle to achieving great wealth. It’s how many can get to $1 million dollars in their 401k by age 60. The people who wonder where their money went often lacked the focus to keep on investing.
Dollar-Cost Average Forever
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 dollar-cost averaging strategy and stick with it forever.
Then track your net worth and your portfolios online to make sure your risk exposure is appropriate with your risk tolerance. You also want to make sure you aren’t paying excessive fees.
I ran my portfolio through a 401(k) 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.
Some of you might be thinking that my dollar-cost averaging strategy is simply timing the markets. You bet your bottom dollar it is. Every time we invest money, we are timing the market whether you like it or not.
The point is that I have a dollar-cost averaging system that works for me. It has given me the confidence to consistently invest for over 25 years. Perhaps my dollar-cost averaging system will give you the same confidence as well.
If you can’t be bothered with dollar-cost averaging, then consider having a hybrid digital wealth advisor like Personal Capital invest your money for you. Once you sign up for their free financial tools, you can get a free consultation with a registered financial advisor to go over your goals and your asset allocation.
In the long run, it is very hard to outperform any index. Therefore, the key is to pay the lowest fees possible while staying invested for as long as possible.
If you want to just manage your money yourself, then Personal Capital has an excellent Investment Checkup tool that x-rays your portfolio for excessive fees and provides asset allocation advice based on your objectives.
Over the long term, you want to invest in stocks. Stocks have traditionally returned 8-10% a year since 1926. Don’t get behind. Use a DCA strategy to help you build wealth. Stock valuations are close to 20-year highs. Dollar cost average is a more appropriate way to invest than ever before.
About the Author. Sam worked in investing banking at Goldman Sachs and Credit Suisse for 13 years. He received his undergraduate degree in Economics from The College of William & Mary and got his MBA from UC Berkeley. In 2012, Sam was able to retire at the age of 34 largely due to his investments. Since 2009, Sam has helped for free millions of people on their path to financial freedom.