Dollar Cost Averaging
When I want to sound smart and intimidate people, I calmly look at them, chew on a muffin for a few seconds, and then throw it against a wall and scream, “DO YOU DOLLAR-COST AVERAGE???”
People are often so impressed that they slowly inch away, then whisper to people around them. I can only guess that they’re discussing how suave and knowledgeable I am.
Dollar-Cost Averaging: Investing Slowly Overtime
Anyway, “dollar-cost averaging” is a phrase that refers to investing regular amounts over time, rather than investing all your money in a fund at once. Why would you do this? Imagine if you invest $10,000 tomorrow and the stock drops 20 percent.
At $8,000, it will need to increase 25 percent (not 20 percent) to get back to $10,000. By investing at regular intervals over time, you hedge against any drops in the price —and if your fund does drop, you’ll pick up shares at a discount price.
In other words, by investing over time, you don’t try to time the market. You use time to your advantage. This is the essence of automatic investing, which lets you consistently invest in a fund so you don’t have to guess when the market is up or down.
Here, we covered your automatic infrastructure. To set up automatic investing, configure your accounts to automatically pull a set 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 big pile of money to invest, what’s the better option: Dollar-cost averaging it or investing the entire lump sum all at once?
The answer might surprise you. Vanguard research found that lump-sum investing actually beats dollar-cost averaging two-thirds of the time. Because the market tends to go up and stocks and bonds tend to outperform cash, investing all at once produces higher returns in most situations.
But—and there are several buts—this isn’t true if the market is going down. (Of course, nobody can predict where the market will go, especially in the short term.) And investing isn’t just about math, but about the very real effects of your emotions on your investing behavior.
In short, most of us already dollar-cost average since we take part of our monthly paycheck and invest it. But if you have a lump sum of money, most of the time you’ll get better returns by investing it all at once.
Buying into Individual Index Funds
Once you’ve got a list of index funds you want to own in your portfolio— usually three to seven funds—start buying them one by one. If you can afford to buy into all of the funds at once, go for it—but most people can’t do this, since the minimum for each fund is between $1,000 and $3,000.
Just like with a target date fund, you want to set a savings goal to accumulate enough to pay for the minimum of the first fund. Then you’ll buy that fund, continue investing a small amount in it, and set a new savings goal to get the next fund.
Investing isn’t a race—you don’t need a perfect asset allocation tomorrow. Here’s how to handle buying multiple index funds over time.
Let’s say you check your Conscious Spending Plan, and it allows you to invest $500 per month after contributing to your 401(k). Assuming all of your funds have a $1,000 minimum, you’d set a savings goal of $1,000 for Index Fund 1 and save for two months.
Once you have accumulated enough to cover the minimum, transfer that $1,000 from savings to your investment account and buy the fund. Now, set up a contribution of $100 per month to the fund you just bought.
Then take the remaining $400 per month set aside for investing ($500 total minus the $100 you’re investing in Index Fund 1) and start another savings goal toward Index Fund 2. Once you’ve saved enough, buy Index Fund 2. Repeat this process as necessary.
Sure, it may take a few years to get to the point where you own all the index funds you need, but remember, you’re taking a forty- or fifty-year outlook on investing—it’s not about the short term. This is the cost of constructing your own perfect portfolio.
Top Tips To Remember
Note: Once you own all the funds you need, you can split the money across funds according to your asset allocation—but don’t just split it evenly. Remember, your asset allocation determines how much money you invest in different areas.
If you have $250 to invest per month and you buy seven index funds, the average person who knows nothing (i.e., most people) will split the money seven ways and send $35 to each.
That’s wrong. Depending on your asset allocation, you’ll send more or less money to various funds, using this calculation: (Your monthly total amount of investing money) (Percentage of asset allocation for a particular investment) = Amount you’ll invest there.
For example, if you’re investing $1,000 per month and your Swensen allocation recommends 30 percent for domestic equities, you’ll calculate ($1,000) (0.3)= $300 and put that toward your domestic-equity fund. Repeat for all other funds in your portfolio.
Finally, if you opt for investing in your own index funds, you’ll have to rebalance about once a year, which will keep your funds in line with your target asset allocation.
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