Nobody wants to be the one person in the room that has no idea what everyone else is talking about. With that said, today we’re going to talk about another term that you might often hear but may not fully understand – dollar cost averaging or DCA. What is it? What are its pros and cons, and how can it help you as a business owner?
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Basically, we’re referring to a simple technique that, if you have a 401(k), you’re probably already using. Dollar-cost averaging (DCA) is the act of investing money at regular intervals over a long period of time. Every time you get paid, you place money into an account. There are so many apps and accounts available to us right now that employ dollar-cost averaging, many of us are practicing the technique without even realizing it. As I already mentioned, the 401(k) utilizes it, but so do many other investment accounts and apps such as Acorn, Robin Hood, and Circle. Technically speaking, placing $200 bucks per week into a personal savings account is dollar-cost averaging. But why should we do it?
Dollar-cost averaging can help us with three key benefits. First, it’s going to help with mistiming the market. I am not a big fan of attempting to time the market. It’s just too unpredictable. With DCA, you’re just investing money and you don’t care what the market is doing. Why? Because you’re investing for a long period of time; so what happens today or tomorrow really doesn’t matter.
The second great thing about dollar-cost averaging is that it takes the emotion out of investing. You’re just putting money into your investment accounts each week, or every other week, or whatever your regular investment interval is, and you aren’t watching to see whether this stock is rising or that one is falling. You’re just investing so that you can make the most of the compound interest and build your long-term wealth.
Speaking of long-term, that brings me to a third benefit of the DCA strategy. Dollar-cost averaging forces us to look at the long view. You see, more than anything, investing is about financial behavior. If you’re focused on the long-term goal and you’re faithful with investing your money, you don’t need to worry about what the market is doing right now, or who’s in office, or what type of trade deals are in place. No, because you are exhibiting sound financial behavior and investing regularly and patiently.
Nothing in life is going to be absolutely perfect. Very few things are simply black and white. The same is true with dollar-cost averaging. We now understand the benefits of DCA, so what are some of the drawbacks? The first that comes to my mind is that you are often buying more frequently. Some companies will charge a commission or a trading fee on each transaction (through the fees per trade are often dropping as time goes on).
Secondly, you could forego gains. Now, unless you’ve got a highly modified DeLorean and your last name is McFly, you probably have little to no chance of knowing that investments X, Y, and Z are going to go through the roof and therefore, invest large sums of cash into those positions at just the right moment. That’s why I say you COULD forego gains. It’s possible that one of your investment positions suddenly spikes and you’ve not taken full advantage of that opportunity. However, the likelihood of timing the market in such a way is pretty slim.
When the financial climate is volatile or bouncing up and down, you are purchasing shares at a harmonic mean value. When the market is up, your regular investment buys fewer shares. However, when the market is down, your money goes further and buys more shares. In the end, your average shows a discount on the shares purchased. Hence, the name dollar-cost averaging.
If you pair your DCA with investing your dividends, you’re basically doubling your dollar-cost averaging. This is why I started this blog, folks. Dollar-cost averaging, like so many other investment strategies, is really simple. That’s why I get so bent out of shape when I hear the Wall Street talking heads trying to make things so complicated.
If you already have a 401(k), then you are already dollar-cost averaging, most likely. However, if you don’t have a 401(k), then you can simply open up a brokerage account. We, at Heritage Investors, use TD Ameritrade Institutional as our custodian; meaning, that’s who we open our client accounts with.
Now, that’s just one of many companies that you could use. You should choose whomever you feel is going to give you the best service for your individual needs. But you basically just need to open a brokerage account, choose a position that you want to invest in, and start putting money into it on a regular basis. That could be weekly, monthly, or even several times per week — as I do, through several investing apps — but the important thing is that you are investing a set amount of money on a regular basis.
Whether you have a 401(k) or not, isn’t important to this strategy because you can contribute your payments to an IRA or a non-qualifying account as well. The thing to remember is that, typically, the more volatile the position you’re investing in, the better the alpha (reward) you could receive.
Let’s say you have a 401(k) portfolio with six or seven different equities. First, we’re going to set the portfolio to rebalance quarterly or monthly. When you get paid, you’re going to deposit your allotted money into the most volatile position possible. For example, let’s assume that emerging markets are the most volatile positions available and you’re using your entire contribution to buy the emerging market position. When the portfolio rebalances, it’s going to sell off the position and reallocate it amongst the targeted allocated positions.
Does it always work? No, but that’s where you have to look at the larger picture. We build the portfolio with a good asset mix and then leave it alone other than the monthly target-band rebalancing. Then, as the client is making their contributions, we are buying the most aggressive investment because it’s bouncing like a basketball, giving us the opportunity to pick up a little bit of alpha by pairing DCA with target-band rebalancing.
RELATED READING: Portfolio Rebalancing and Target-Band Rebalancing – The Basics
So, look, you don’t have to have a degree in finance in order to succeed at investing. This is really as simple as it gets. If you still feel like you need some help, that’s fine. I have an entire team of advisors that would love to help you find your path to financial success. Life is hard. It can be complicated but with a little knowledge, we can at least make investing financially simple.
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