Dollar Cost Averaging

If I want to sound smart and intimidate people, I’ll look at them calmly, chew on a muffin for a few seconds, then throw it against a wall and yell, “WILL YOUR DOLLAR COST MAKE AVERAGE???” People are often so impressed that they slowly move away and then whisper to the people around them. I can only assume they are discussing how polite and knowledgeable I am.

Dollar cost averaging: Invest overtime slowly

Anyway, “dollar cost averaging” is a term that refers to investing regular amounts over time, rather than putting all of your money into one fund at once. Why would you do that? Imagine you invest $10,000 tomorrow and the stock falls 20 percent. At $8,000, it needs to rise 25 percent (not 20 percent) to get back to $10,000. By investing at regular intervals over time, you hedge against falls – and if your fund falls, you get shares at a reduced price. In other words, when investing for the long term, don’t try to time the market. You use the time to your advantage. This is the essence of auto investing, which allows you to invest in a fund consistently, so you don’t have to guess when the market is going up or down.

We’ve got your automated infrastructure covered here. To set up auto investing, configure your accounts to automatically withdraw a specified amount of money from your checking account each month. See details. Remember: if you set it up, most funds waive transaction fees.

But here’s a question: if you have a large pile of money to invest, what’s the better option: dollar costs on average, or invest the entire lump sum at once? The answer might surprise you. Vanguard research has found that lump sum investments actually outperform dollar costs an average of two-thirds of the time. As the market tends to rise and stocks and bonds tend to outperform cash, investing all at once will yield higher returns in most situations. But – and there are several buts – this is not true when the market is falling. (Of course, no one can predict where the market will go, especially in the short term.) And investing isn’t just about the math, it’s about the very real impact of your emotions on how you invest.

In short, most of us already cost a dollar on average since we take a portion of our monthly paycheck and invest it. But if you have a lump sum of money, you can usually get better returns by investing all at once.

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Purchase in individual index funds

Once you have a list of index funds you want in your portfolio — usually three to seven funds — start buying them one at a time. If you can afford to buy into all of the funds at once, do it — but most people can’t, as the minimum for each fund is between $1,000 and $3,000.

Just like with a target fund, you want to set a savings goal to accumulate enough to pay the minimum of the first fund. Then you buy that fund, keep investing a small amount in it, and set a new savings goal to get the next fund. Investing is not a race – you don’t need perfect asset allocation tomorrow. Here’s how to deal with buying multiple index funds over time.

Let’s say you review your Conscious Spending Plan and it allows you to invest $500 per month after contributing to your 401(k). Assuming all your funds are a minimum of $1,000, you would set a savings goal of $1,000 on Index Fund 1 and save for two months. Once you’ve accumulated enough to cover the minimum, transfer that $1,000 from savings to your investment account and buy the fund. Now set up a $100 per month contribution to the fund you just bought. Then take the remaining $400 a month you’ve set aside for investing ($500 total minus the $100 you invest in Index Fund 1) and start another savings goal for Index Fund 2. Once you’ve saved enough, buy You index funds 2. Repeat this process as needed. Sure, it may take a few years to get to the point where you own all the index funds you need, but remember that when you invest, you have a 40- or 50-year perspective — it’s not about the short term view. This is the cost of building your own perfect portfolio.

Top tips to remember

Note: Once you have all the funds you need, you can split the money between the funds according to your asset allocation – but not just split it evenly. Remember that your asset allocation determines how much money you invest in different areas. If you have $250 a month to invest and you buy seven index funds, the average ignorant person (ie most people) will split the money seven ways and send each $35. That’s wrong. Depending on your asset allocation, you’re sending more or less money to different funds with this calculation: (your monthly total of money invested) (percentage of asset allocation for a given investment) = amount you will invest there. For example, if you invest $1,000 per month and your Swensen allocation recommends 30 percent for domestic stocks, calculate ($1,000)(0.3) = $300 and put that in your domestic stock fund. Repeat for all other funds in your portfolio.

If you do decide to invest in your own index funds, you’ll need to rebalance about once a year to keep your funds consistent with your target asset allocation.

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