Dollar Cost Averaging

Buying in bulk saves money. Buying things when they’re on sale saves money. If you know these are true, why aren’t you applying them to your investment strategy?

My breakfast consists of three eggs daily, so I buy two two dozen packs to avoid frequent grocery runs. But when I saw the $8.19 price this morning at Meijer, I decided to buy only one, hoping prices would go down before I needed more. Last year, I recall receiving a coupon for $3 off $10 worth of eggs. At that time, a dozen eggs were selling for around $1.50, so I walked out of the store with 7 dozen! 🥚

While my egg-buying habits may seem excessive, most people tend to buy more of something when it’s cheap and less when it’s expensive. Except for stocks. When a stock goes on sale, most people sell. And when a stock is expensive, everyone rushes to buy more! Even though this is the worst possible strategy. At its essence, dollar-cost averaging is a habit that forces us to execute the proper strategy! Periodically investing a fixed sum of money ensures we buy more when stocks are cheap and less when they’re expensive. Thus, our average cost tends to be lower.

It’s an eloquent example of how mathematics matter in real life!

Let’s assume that we have $5200 to invest each year. That’s $100 each week. Week 1, the stock price is at $20, so $100 buys us $5 shares. Week 2, the stock price falls to $10, so $100 buys us 10 shares. Week 3, the stock price increases to $25, so $100 buys us 4 shares.

If we had perfect foresight, we would have spent all $300 in Week 2. Lacking perfect foresight, the next best strategy is to dollar-cost average our way to an average of $15.79. It’s also the simplest strategy to execute and requires no ongoing effort once set up. Easiest, simplest, AND best? Sign me up!

But what is the ideal frequency?

For many years, I’ve had an auto-draft setup with Vanguard to pull money every other week. This aligned with my pay periods from when I was a W-2 employee. I recommend starting this way for the psychological benefits. It minimizes the pain of missing that money since it’s gone before you even know it’s there. It’s like Dave Ramsey’s debt snowball method of paying off one’s lowest balance debt first. Mathematically, it’s best to pay down the debt with the highest interest rate. But psychologically, paying off one debt completely creates a feeling of momentum. And a hit of dopamine. This encourages people to continue following the plan instead of giving up. 

James Clear concluded his book Atomic Habits: “You do not rise to the level of your goals. You fall to the level of your systems.” Better systems translate into better results!

It may not matter what the optimal period is. The average American saves $2.4 dollars for every $100 they receive. If this is you, start with what you can when you can.

There’s a profound Chinese Proverb that declares “The best time to plant a tree was 20 years ago. The second best time is now.”

After you’ve built the habit of investing, you’ll build affluence. The answer to the ideal frequency may become relevant, so allow me to reveal the answer in a story.

While on a road trip with a friend, he said he invests $6000 on January 1 of each year to max out his Roth IRA. He claimed this was annual dollar-cost averaging. I was skeptical. It seemed too infrequent to overcome the swings of the market. He reminded me that the market’s long-term trend is upwards. He claimed it’s better to get all the money in sooner than to split it up over time.

I tested this hypothesis by downloading the daily S&P 500 prices from 12/30/1980. ¹ I then simulated investing daily, weekly, monthly, and yearly. Annual investments on the first of each year resulted in the highest returns in almost all cases!

Zooming out on the temporal scale even further crystalizes this insight. Investing $10k 100 years ago is superior to investing $100 once per year for the last century. This is because of the time value of money. $100 invested one year ago has only one year of compounding. Lower initial values matter much less than the number of years it has to compound because compounding is exponential. So invest your entire annual amount as soon as possible if possible. Otherwise, do as much as you can as soon as you can.

Time in the market is more important than dollar-cost averaging. But combining both strategies is best.