Investments

What Does DCA Mean

By David Krug David Krug is the CEO & President of Bankovia. He's a lifelong expat who has lived in the Philippines, Mexico, Thailand, and Colombia. When he's not reading about cryptocurrencies, he's researching the latest personal finance software. 7 minute read

Congratulations! The time has come for you to start investing some of your savings so that they may begin working for you instead of you for them. Rather than diving headfirst into the stock market, you decide to start small by investing in a few index funds. However, there is still the matter of when, in addition to what, you should invest in before you go all in at once.

This question can be answered in one of three ways by most investors. You may put money away in chunks anytime you get a windfall. Market declines can be used as opportunities to “buy the dip,” or make opportune investments. There’s also a method called dollar-cost averaging, when you invest a certain amount every month.

Keep in mind that they are not day trading or swing investing tactics; rather, they are methods of long-term investing. Trading and investing use different mathematical ideas and techniques.

Dollar-cost averaging, as opposed to trying to time the market, almost always produces greater results for long-term investors, especially casual, passive investors. This is the reason why.

What Is the Process of Dollar-Cost Averaging?

Dollar cost averaging may sound like a complex financial strategy, but in reality, it’s one of the simplest concepts to grasp. It means putting money away regularly, at regular intervals, in the same assets.

Let’s say, for the sake of argument, that you set aside $300 every month to go toward investments (you already have an emergency fund saved). Simplify your portfolio by spreading your money among three index funds: one for large-cap U.S. equities, one for small-cap U.S. stocks, and one for international companies.

You put $100 into each of those three funds every single month. All done. You don’t need to attempt to timing the market or do anything fancy; you may just maintain investing on a regular basis. By investing gradually throughout time, regardless of the market’s ups and downs, you may reduce the danger of losing all your money in a single plunge while still taking advantage of gains.

Even if your payments are sporadic or lumpy, you may use dollar-cost averaging to get the most of your money. Let’s pretend you obtain a $3,000 tax return and decide to put that money to work for you by investing it. Altering your monthly investments over the course of, say, the following year is preferable to dumping it all into the market at once. As a result, you would be investing $550 a month, or an extra $250 per month, instead of the usual $300.

Remember that you may spread out your monthly investment rather of making one large payment. To reduce the risk of having large swings in value, I invest regularly but not more frequently than once each week. Using the previous illustration, it translates to spending around $70 per week rather than $300 per month. It’s up to you how often you want to invest, whether it’s once a week or once a pay period.

The Reason for Dollar-Cost Averaging

In order to achieve a similar average return over time to the fund or stock you are investing in, dollar-cost averaging might be used. Because of this, you may invest with less of a personal interest in it. That’s significant because investment mistakes are often made when investors let their emotions get the best of them.

The ordinary investor underperforms the market on a regular basis, according to studies, since they sell low when everyone else is panicking and purchase high when everyone else is flocking into the market. DALBAR conducted an investigation demonstrating that the average investor achieved nearly half the returns that the S&P 500 provided over a 20 year period.

The following arguments in favor of dollar-cost averaging should help sway any remaining doubters.

Reduce your risk by not attempting to time the market.

Trying to timing the market is one of the most prevalent financial blunders made by high earners. Experts in their fields tend to relish challenges that allow them to showcase their skills. The problem is, they always end themselves in hot water when they give in to that temptation.

There are a number of arguments against stock market timing. Firstly, the price drop that occurs next month can still be bigger than the current one. Therefore, the active trader who stays on the sidelines hoping for a downturn to purchase still usually spends more than the passive trader who dollar-cost-averages over the whole market.

Also, the irrationality and unpredictability of markets. They rise and fall not simply on economic principles but also on human feeling. Not to mention the influence of speculators and day traders on stock prices, or the role played by automatic stop-loss orders in setting off widespread market declines.

And there’s the dividend income and compounding magic you’re passing on by staying on the sidelines.

Consistent Investing Increases Returns Through Dividends and Compounding

Annualized returns from the stock market tend to hover around 10% over longer time periods. Without dividends, however, the returns fall to about 6%.

The compounding effect of dividend reinvestment cannot be overstated. Most exchange-traded funds and mutual funds distribute dividends, which can be used as a source of income or reinvested to purchase further shares, each of which will eventually distribute dividends and increase in value.

You waste your money if you wait for the “perfect time” to invest it by trying to timing the market and purchase a drop. It is not rising in value, not compounding, and not paying dividends at all throughout this time.

Passive Investing & Automation

Individual stock picking, day trading, and market timing are all activities that need training and experience before one can adopt even a somewhat educated stance. Time is required for both the training and the actual implementation of these strategies.

Another strategy is to use automated dollar-cost averaging. When working with a robo-advisor or investment adviser, all you have to do is set up periodic, automatic deposits into your brokerage account, and they will invest the money for you in the funds or other investments you have chosen in advance.

Nothing to worry about, no need to spend hours studying through the day’s market data. It’s easy to amass riches while focusing on the more vital aspects of life, such as work, family, and hobbies.

It’s not necessary to spend a fortune on automation software either. SoFi Invest and Schwab Intelligent Portfolios are two of the top robo-advisors, and they don’t cost anything to use.

Fun Money vs. Core Investing

I, too, am susceptible to the temptation of investing in an attempt to feel superior to the market. Nonetheless, I found out the hard way just how pricey it can be.

So, I set guidelines for myself. I have first and foremost settled on a basic, core investment approach based on dollar-cost averaging into a variety of index funds. I use a robo-advisor to invest more than 90% of my monthly stock-market savings.

But I keep a little amount in a savings account as “fun money” to invest if I get the gut feeling (emotional warning!) that a good opportunity exists in the market.

Fun Money Option 1: Buy the Dip

You can try your hand at market timing with some of your disposable income, provided that the vast bulk of your investment capital is invested in a disciplined manner in accordance with your core investing strategy. The key is to only put away money for entertainment that you wouldn’t mind seeing its value drop or even disappear. Consider it more of a leisurely $50 expenditure than a serious attempt at building wealth.

When the market drops by 5-10%, I tend to purchase more stock. In times of widespread panic, I like the opportunity to take a stance at odds with the herd. Successful outcomes are commonplace. Yet, this is not always the case. That’s why I just do it for the extra spending money.

Fun Money Option 2: Chose Stocks

Need proof that you’re better than the average investor? Instead than attempting to time the market, educate yourself on stock picking.

An in-depth study can help you find cheap stocks and provide you a competitive edge. However, it requires study, practice, and experience. If you want to choose stocks but aren’t sure where to start, the CAN SLIM strategy could be for you.

Any stock’s price can be bought down, not only the market as a whole. Occasionally, I will buy shares of a firm that has solid fundamentals but saw its stock price decline due to a public relations misstep or some other temporary setback that has nothing to do with the company’s long-term profitability. I’ll resell them when they’ve appreciated by 10% to 15%.

I don’t want to have to keep tabs on company news or stock performance over the long haul, and I don’t have the time to do so. Because people are so forgetful, I programmed sell orders to trigger when the public has forgotten the original reason for selling and has begun buying again. My newfound wealth was re-invested in line with my original plan of action.

Bottom Line

Despite the attraction, statistically speaking, market timing almost never works.
It’s fine to treat yourself occasionally by putting some cash aside. If you really need to scratch that itch, go ahead and do it, but don’t spend more than 5–10% of your overall savings on investment.

Stick with the tedious, tried-and-true way of growing rich slowly through steady, diversified investments as your primary investment plan. It’s not flashy or bragging-worthy (about beating the market), but it does the job.

In the end, it’s not how smart you were along the road that matters, but rather whether or not you were able to achieve your long-term financial goals, such as retiring comfortably.

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