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In Investing

Dollar Cost Averaging: An Overview

September 6, 2022

Dollar cost averaging is a very simple, yet very effective approach to investing. Dollar cost averaging is a long term investing strategy that is implemented by investing a fixed amount of money into the same stock or fund over a period of time.

A common saying among investors in support of dollar cost averaging is “time in the market beats timing the market.” The idea behind this saying is that investing in the market over a long period of time will outperform attempts at trying to make perfect trades by buying at the lows and selling high. No one truly knows when the market is low or high. This means that you are losing opportunity by not being in the market sooner. The market is unpredictable and by using this method you greatly reduce your risk. Chances are, if you contribute to a 401k, 457b, 403b or similar employer sponsored retirement plan, you are already implementing a dollar cost averaging strategy, unless you are switching funds frequently.

How To Implement a Dollar Cost Averaging Strategy

There are typically a few ways that a dollar cost averaging strategy is used. As talked about previously, your retirement plan at work is likely dollar cost averaged. You contribute a certain amount into your 401k, for example, every week, bi-weekly or maybe even monthly. Another example would be maxing your Roth IRA each year with one lump sum contribution. This is dollar cost averaging on an annual basis rather than per pay period like your 401k might be, but the premise is the same.

Similarly, you may contribute to an individual account in which you manually invest money weekly, bi-weekly, monthly, etc. Assuming you put money into the same funds/stocks on a regular basis this is another form of dollar cost averaging. Even automatically reinvested dividends could be considered dollar cost averaging. This would typically be on a quarterly basis.

Another commonly used application is when one has a lump sum of money they want to invest. Rather than investing all the money at once, they will invest the money across periodic intervals. This tends to make people feel like they are lessening their risk, but as we will talk about later on it may be counterintuitive.

Dollar Cost Averaging: In Practice

Dollar cost averaging allows you to purchase more shares when the price is low and fewer shares when the price is high. This gives you an average price per share somewhere in the middle.

Let’s use our friend Tom as an example. Tom is a new investor and has decided to start investing on January 1st. Tom will invest $1,500 per month, on the first of each month, into an index fund called ABC. Looking forward six months, the price of ABC on January 1st is $50, February 1st – $54 dollars, March 1st – $42 dollars, April 1st – $45 dollars, May 1st – $46 dollars and on June 1st – $53 dollars.

Each month Tom’s $1,500 would have bought a different number of shares.This is due to the difference in share price.

To calculate how many shares Tom can purchase each month we will divide the amount invested by the price of the shares at the time. Here’s the math for January: $1,500 invested / shares of ABC at $50 each = 30 shares.

January – 30 shares, February – 27.78 shares, March – 35.71 shares, April – 33.33 shares, May – 32.61 shares and June – 28.30. After six months, Tom would own a total of 187.73 shares of ABC with an average cost of $47.94 per share ($9,000 invested / 187.73 total shares = $47.94). He invested a total of $9,000 that is now worth $9,949.69.

It is important to note that this example worked out favorably for Tom because of the overall increase in share price of our hypothetical fund called ABC. Dollar cost averaging does not reduce the risk associated with a market decline. It can though, potentially increase the performance of an investment, providing the price of the investment increases over time. This is why dollar cost averaging the entire market, or more likely a fund that tracks the market, which has historically gone up over time, is a popular strategy.

Potential Drawbacks

There are a few potential drawbacks to a dollar cost averaging strategy. The first potential drawback to dollar cost averaging is the possible loss of gains. For example, if Tom could have predicted the future and invested the entire $9,000 on March 1st when the shares were the lowest, he would have seen a $2,356.84 gain by June 1st. Conversely, if he had invested the entire $9,000 on February 1st when the shares were the highest, he would have seen a loss of $163.49. This drawback is only relevant if you are successfully able to buy and sell at the perfect time. Unfortunately, most of us don’t have the ability to see the future.

The next potential drawback is the potential for increased broker fees by making more trades. There are many low cost brokerages and more and more that offer free trades out there, making this much less of an issue than it once was.

Lastly, the reason that dollar cost averaging makes sense is the same reason that it might not. The idea is that the market will go up over time so buying over consistent time periods will allow you to capitalize on this. By not investing as much as you can, as soon as you can, you are, in theory, allowing the market to rise before investing more. This really only applies when dollar cost averaging a lump sum of money though. You can’t invest money that you don’t have.

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In Financial Independence

$300k is Half Way to One Million

January 30, 2021

While working towards financial independence $1,000,000 is often seen as a coveted milestone. This is a goal that can take a lifetime to achieve, but we know with a high savings rate this can be achieved much faster. Saving your first $100,000 is the hardest and takes the longest. Fortunately, each $100,000 after that becomes easier and comes faster. Compound interest becomes more and more impactful the larger your money grows.

We all know that $100,000 is only 10% of $1,000,000. What’s more interesting, is what percentage of the total time taken to get to $1,000,000 is occupied by the first $100,000. We’ll look at the $300,000, $500,000 and $750,000 milestones as well.

$300,000 is Half of $1,000,000

If I told you that $100,000 is 25% of $1,000,000, or that $300,000 is 50% of 1,000,000, you would probably look at me like I’m crazy. You would inform me that $100,000 is 10% and $300,000 is 30%, respectively, of $1,000,000 and ask me what I’m talking about?

What I should say is that $100,000 requires 25% of the total time that it takes to get to $1,000,000. And $300,000 requires 50% of the total time that it takes to get to $1,000,000. How is this possible? Compound interest! Take a look at the chart below:

	$5,000	$10,000	$20,000	$30,000	*Average*
$100,000	12.37 Years – 31.64%	7.44 Years – 24.91%	4.19 Years – 19.52%	2.92 Years – 17.07%	6.73 Years – 23.29%
$300,000	23.57 Years – 60.28%	16.06 Years – 53.77%	10.11 Years – 47.11%	7.44 Years – 43.48%	14.30 Years – 51.16%
$500,000	29.87 Years – 76.39%	21.46 Years – 71.84%	14.33 Years – 66.77%	10.90 Years – 63.71%	19.14 Years – 69.68%
$750,000	35.19 Years – 90%	26.26 Years – 87.91%	18.32 Years – 85.37%	14.33 Years – 83.75%	23.53 Years – 86.76%
$1,000,000	39.1 Years – 100%	29.87 Years – 100%	21.46 Years – 100%	17.11 Years – 100%	26.89 Years – 100%

The top lines of $5,000, $10,000, $20,000 and $30,000 represent amounts invested each year earning an annualized 7% return. The side columns of $100k, $300k, $500k, $750k and $1M represent investment milestones.

The purpose of this chart is to illustrate how long it will take different annual investment amounts to hit each milestone, in years and what percentage of the total time to reach $1M each of these milestones will occupy. For example, looking at the $10,000 annual investment, it will take 7.44 years to reach $100,000 and 29.87 years to reach $1,000,000. The 7.44 years that it took to reach $100,000 was a total of 24.91% of the total time of 29.87 years it would require to reach $1,000,000. Making $100,000 25% of 1,000,000! In the same $10,000 column, it would take 53.77% of the total time required to reach $300,000. This means that half of your time would be spent earning the first $300,000 and you would earn the next $700,000 in that same amount of time! This is what I meant when I said that $300,000 is half of $1,000,000.

Average

I took the average between each of the annual investment amounts time and percentage required to reach each milestone. With that information I created the chart below:

This chart illustrates how much faster each milestone past $100,000 is reached. You can notice how much flatter the line to $100,000 is compared to the rest of the milestones. The averages worked out to be 6.73 years – 23.29% to $100,000, 14.30 years – 51.16% to $300,000, 19.14 years – 69.68% to $500,000, 23.53 years – 86.76% to $750,000 and 26.89 years to $1,000,000.

Using these averages, it took 6.73 years to reach $100,000. Another 7.57 years to reach $300,000. Just another 4.83 years to reach $500,000. Only another 4.39 years to reach $750,000. Finally, another 3.36 years to reach $1,000,000. The difference is pretty remarkable. It took 6.73 years to accumulate the first $100,000 but only 3.36 years to accumulate the final $250,000.

Conclusion

The power of compound interest is incredible. The sooner you can let it start working for you the sooner you can achieve financial independence. Each milestone will come exponentially sooner than the last. Hustle and grind to your first $100,000 so that your journey becomes easier! Tell all your friends that $300,000 is half of $1,000,000 and let me know the crazy remarks that they give you before you explain!

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In Personal Finance

5 Quick Tips To Save More In Your 20s

November 23, 2020

Making small, avoidable mistakes with your money in your 20s can have a significant impact on your overall financial health as you get older. Creating good financial habits while you’re young will give you the ability to get ahead. Saving money in your 20s can give you the freedom to buy a house, switch jobs and even retire early. These 5 tips will get you started in the right direction.

1.) Start Investing

Compound interest is one of the most impactful financial assets available. Interest is the amount earned on the initial principle, compound interest then occurs when you earn interest on your interest and your initial principle. An extra few years of compound interest can amount to a massive amount of money.

2.) Contribute Enough Into Your 401(k) To Get The Maximum Match From Your Employer

The way 401k match typically works is the employer will match a percentage of employee contributions, up to a certain percentage of the employees total salary. For example, an employer might match 100% of an employees contributions up to 3% of their total salary. If the employee earns $50,000 annually the employer will match up to $1,500. This is essentially $1,500 for free. In order to get the maximum match from the employer the employee would need to contribute $1,500 to their 401k. Anything contributed past $1,500 would be unmatched. Contributions into a 401k are tax deferred so there are benefits past just the match from the employer.

3.) Send Some Of Your Paycheck Directly To Your Bank Account

Having an emergency fund saved is one of the most important parts of your financial health. Should a large financial expense arise or if you need to be without income an emergency fund will keep you afloat for a few months. An emergency fund is generally 3-6 months worth of expenses saved in cash or other highly liquid assets. Send enough of your paycheck directly to your bank account to replace all your expenses and maintain your emergency fund.

4.) Think Rationally Before Making Large Purchases

While saving money early on in life is imperative to financial success, spending large amounts of money can be detrimental. Before making large purchases it is important to weigh all of the options. If there’s a need for a vehicle, does it absolutely need to be a brand new vehicle or will a lightly used vehicle work? Is carpooling, walking or cycling an option? How soon is a vehicle needed? Rushed decisions tend to cost more money. If the large purchase is a want rather than a need think about what kind of value it will bring. How many hours of work will be required to afford the purchase? Is there any other option that will provide similar value? Considering many factors regarding large purchases can help to avoid regretful mistakes.

5.) Set Large Obtainable Goals

Set challenging but not unobtainable goals for yourself. Setting goals that you know are too easy won’t motivate you and instead will make you lose interest. Set goals that you’ll constantly have to work towards to make happen. Set both short term and long term goals to keep you focused on smaller immediate goals as well as larger, longer term goals.

The decisions that you make in your 20s will impact your financial health more than any other decade of your life. Now is the time to build a solid foundation to build lasting wealth on. With some discipline and forward thinking anyone can give their finances a great head start.