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.
A Better Dollar Cost Averaging Strategy
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. Volatility came back with a vengeance in 4Q2018, remained steady for most of 2019, until it struck again in August 2019.
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 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?
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%.
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 Investment Performance To A Risk-Free Rate
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 and the 10-year government bond yield 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.
Whenever an index ETF is providing a greater dividend yield than the 10-year bond yield, that is one of the main buying indicators in my opinion.
No Need To 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 $19,000 and investing $730 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. The people who wonder where their money went often lacked the discipline to keep on investing.
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 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 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.
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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.
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 that now generate roughly $250,000 a year in passive income. His most favorite right now is in real estate crowdfunding to take advantage of lower valuations and higher cap rates in the heartland of America. He spends time playing tennis, taking care of his family, and writing online to help others achieve financial freedom too.
Updated for 2020 and beyond.