What is the most cost-efficient and profitable approach to long term investing? Market timing works for some folks. But recently, broad-based ETFs have outperformed many managed funds. Investing in stocks works best when the investor starts early and invests regularly. It helps to buy stocks directly in order to cut out fees and commissions so dividend reinvestment plans are a good idea as well. While there are always opportunities in the stock market, most people in their working years do not have the time, expertise, or interest required to take advantage of them. Thus, the best approach for most investors is to invest in a selection of conservative stocks with long track records of dividend payments and always reinvest dividends. Alternatively, an investor can simply invest routinely in an ETF that follows the S&P 500. With either choice, the best approach is to use dollar cost averaging.
Dollar Cost Averaging
Dollar cost averaging is an investment approach in which a person invests the same dollar amount every pay period, month, quarter, or year. The first practical advantage of this approach is that a person can budget how much they will invest from every paycheck, bonus check, or whatever. The second practical advantage is that dollar cost averaging keeps you from investing too much when stocks are expensive and allows you to buy more when stocks are cheap.
Ideal Ways to Apply Dollar Cost Averaging
Smart investors take advantage of the tax benefits of an IRA or 401(k) plan from work. And, if your employer adds a little to your 401(k), so much the better. Simply select an amount to invest in either, or both, of these investment vehicles and stick with it year after year. When the stock market is overpriced you will not be tempted to pay too much and when the market is soft, you will get more stocks for your money.
Dollar cost averaging also works if you are using a mutual fund as an investment vehicle and especially if you are investing in an ETF that tracks the S&P 500 or another broad-based market index.
(Investopedia, Dollar Cost Averaging)
Benefits of Dollar Cost Averaging
As we noted at the beginning of this article, timing the market works for some folks. But, these folks have tons of available cash, the time and expertise to analyze intrinsic stock value on many potential investments, and the experience needed to â€œpull the triggerâ€� at the right time to buy or sell most profitably. These folks are not the average investor who wants to put a little money aside with each paycheck and needs to know the best way to do this. For most folks, dollar cost averaging with a reliable set of investments is the way to go.
Motif discusses the real world of mom and pop investors and the benefits of dollar cost averaging.
A lot of people have a tendency to spend any leftover money in their bank accounts after all their bills are paid each month instead of investing for their retirement. In cases like these, using the disciplined trading approach of dollar cost averaging not only prevents them from procrastinating on their investing goals, it also helps them save for retirement and avoid wasteful spending.
Dollar cost averaging can also help investors who tend to be hesitant with investing and hoard cash out of fear or uncertainty. Having some cash on hand can provide peace of mind during volatile markets, but holding too much cash for too long can weigh down your portfolioâ€™s return over time due to inflation. Plus, dollar cost averaging can help investors put their money into the market as quickly as possible on a consistent basis.
In writing about investing, we commonly deal with issues like fundamental analysis, best stocks to invest in, and where the market is likely going next. But, the folks at Motif hit the nail on the head in their discussion of the benefits of dollar cost averaging as it applies to the average investor who needs to develop a disciplined and reliable approach to putting money away and letting it grow for their retirement. Dollar cost averaging helps investors make their investments in a routine fashion and alleviates the risk of making bad decisions when trying to time the market or pick individual investments.
Dollar cost averaging in a bull market keeps an investor from buying too much when prices are too high and dollar cost averaging in a bear market lets an investor purchase at bargain prices when the market is bottoming out. When considering dollar cost averaging versus timing the market, most folks do just fine with an ETF tracking the S&P 500 and dollar cost averaging.
Mistakes to Avoid in Dollar Cost Averaging
US News and World Report has some good advice about following the rules mistakes to avoid in dollar cost averaging. Here are the high points of their slideshow.
Not Starting Dollar Cost Averaging Investing Early Enough
This is a practical and profitable approach to investing and to get the most out of it you need to get in early and take advantage of the compounding effect of steadily growing investments.
Not Being Consistent with Dollar Cost Averaging
This approach works when you apply it routinely. When you start second-guessing the system you are trying to time the market. Consistency pays off with dollar cost averaging.
Keep Your Investment Portfolio Balanced
If you have your money in an ETF that tracks a broad market index or in a mutual fund with the same properties, this is not an issue. But, if you have a nice selection of dividend stocks and AAA bonds, one may outpace the other. At some point, you may want to rebalance your portfolio or simply start using the ETF approach.
Letting Fear or Greed Control Your Investing
U.S. News notes that investors tend to abandon the dollar cost averaging approach at the worst possible times, such as when a bull market is about to collapse and they lose money. Or they sell everything just as a bear market is about to rebound. The point of dollar cost averaging is to pick a broad-based set of investments and stick with the investment program through thick and thin. Let the dollar cost averaging approach work its magic in both up and down markets over the years.
Not Keeping Track of the Costs of Investing
Dollar cost averaging works for a wide range of investment choices. But, if you are paying an old fashioned stock broker huge commissions for small investments every two weeks, you need to rethink your approach. Likewise, if your mutual fundâ€™s fees are eating up your gains, perhaps an ETF that does not charge management fees will be a better choice. But, no matter which you use, dollar cost averaging, correctly applied is a good long term investment approach.
What Makes Dollar Cost Averaging Work for the Average Investor?
The first thing for an investor to do is to get started early in life. The beauty of dollar cost averaging with an ETF that tracks the S&P 500 or one of its sectors is that the investor does not need to have done a lot of research in picking good investments. The next benefit is that the investor develops a discipline early in life that becomes an investing habit. Then, the compounding effect of good investments takes over to create wealth over the years.