What is dollar-cost averaging?
Dollar-cost average, or DCA for short, is quite simply investing your hard-earned cash into a portfolio of funds or stocks of your choosing on a set schedule.
The most common example is taking a portion of your paycheck every time you’re paid, let’s say $500, and distributing it into a mix of index funds or ETFs every two weeks.
It’s a passive investing strategy that allows you to build up your investments over time so that you can ultimately reach your financial and retirement goals.
One of the main advantages of DCA is that it is more automated. You’re taking out the guesswork of investing.
If you follow my channel, then you know that I share what I call the Freedom of Choice lifestyle, and one of the pillars is called Financial Discipline.
If you don’t follow my channel, I invite you to Subscribe now, and also hit that Like button 🙂 Or hit it later when I actually give you more value.
Now, a part of Financial Discipline is automation. The funny thing about personal finance is that most people don’t want to even think about it, but they want to reap the benefits of financial freedom.
The best way to do so is by automating the process. Dollar-cost averaging allows you to do this. And I’ll share specifically how to do so later in the article.
By doing DCA, you’re not trying to figure out the market’s highs and lows. You’re “robotically” adding money into your investment portfolio on a timed schedule.
This makes your investing strategy way less stressful because you’re not trying to time the market. You’re simply allowing your funds to work its magic in the long-term horizon via appreciation, dividends, re-investment of those dividends, and of course the wonder of the investment world: compounding.
How dollar-cost averaging can beat professional money managers
As you’re read this and you’re someone who is thinking, “I can totally beat or time the market”, here are some stats to show you otherwise.
Let’s take large-cap managed equity funds and compare it to the S&P 500 as a benchmark.
In other words, can professional money and fund managers outperform the S&P 500?
The hope, of course, is that they do because you’re paying them handsomely to give you a bigger return.
However, the data says otherwise.
In year 1, 63% of large-cap funds failed to outperform the S&P 500 benchmark.
From there, it gets progressively worse. By year 5, 84% have failed to outperform the S&P 500.
And by year 15? Over 92%.
So what does the data show? It shows that while some funds can beat the S&P 500 in the short-term, the majority of them will not in the long-term.
If professional money managers and investors who do it on a full-time basis can’t beat the market, what are the odds you will?
Now, I’m not saying you can’t, but the average retail investor just likely won’t be able to without doing the proper research and diligent work behind it.
And that’s why DCA is attractive to most investors. Dollar-cost averaging is a long-term strategy that takes away the stress of growing your money.
It’s the “zen way” of investing so you can concentrate on all the other parts of your life besides money.
So, now that you understand what DCA is, one of the first things you have to figure out in your dollar-cost averaging plan is the type of portfolio and diversification you want to build out.
This really depends on several factors such as:
- Risk tolerance
- Current age and
- Your retirement goal and timeframe
And based on those factors, here’s a general rule of thumb: the closer you are to retirement age, the less risk you want to take in your portfolio. This typically means fewer stocks and more bonds. Although this seems to be changing a bit in today’s investing climate.
So far, traditionally when you’re young, it is advised to have a higher percentage of stocks versus bonds in your portfolio because it has a higher chance of appreciation, especially over time.
Ultimately how you adjust the risk in your portfolio is totally up to you. The important thing is to set up a strategy and stick with it.
If you’re more risk-averse, then you can play it safer.
My Personal Dollar-Cost Averaging Story
Now, I want to share my own personal dollar-cost averaging story with you.
When I first started my career in 2008, it was when the market crashed because of the mortgage crisis.
And because I’ve naturally always been really curious about learning personal finances and investing, I was stoked that the markets were on sale.
There’s a quote by the legendary investor Warren Buffett that says, “Be fearful when others are greedy and greedy when others are fearful.”
I saw the crash as my opportunity to be super greedy and capitalize on the funding of investments with my new salary as a working professional.
So I poured 75% of my paycheck directly into an index fund of the total US stock market, international markets, and Real Estate Investment Trusts, also called REITs.
I chose the total US stock market index fund because I did not want to choose individual stocks then.
Then I added an international market fund to diversify globally.
And finally, I didn’t have the funds to buy real estate yet, so I invested in REITs. These funds produce high dividend yields.
That mix was my DCA portfolio. And like clockwork, every time a paycheck came in, I took 75% of my net total and put it into those funds.
I’ll also note that I was able to throw in so much of my paycheck because I was living at home with my parents. Look, I have no shame about that. I know that some people think it’s time to be independent when you’re 22 years old and you need to live by yourself to become an adult.
I am not in that school of thought.
I was ready to save up as much as I could while I was young so that I can set my future life up for success.
If you truly want to be financially independent and retire early, it helps tremendously to get a headstart on your finances.
That seemingly small decision gave me the jumpstart I needed to ultimately set up my financial discipline and foundations, as well as the capital I needed to fund my own startups.
Thanks mom and dad <3 I wouldn’t be where I am without you
If you’re currently still in your 20s and you’re embarrassed to say that you live at home with your parents because of societal norms or the dating world frowns upon it, I have one question for you…
Do you care more about what these probably not-so-important people say and think about you, or do you care more about your financial freedom and living the life of your dreams because you’ve built up your financial cushion so that you have the flexibility to do whatever you want in life.
In my opinion, the choice is pretty clear.
And if that doesn’t convince you enough, here’s a quick calculation on how my financial situation would have looked if I didn’t save 75% of my paycheck during the first 3 years.
I would have had at least $2,000 in monthly expenses between rent and miscellaneous costs that came with living on my own. And in my area, that $2k per month is pretty conservative.
At $2,000 per month in extra expenses, that would be $24,000 per year and $72,000 in the 3 years that I was working in corporate before launching my first startup.
When I first started dollar-cost averaging in the fall of 2008, the S&P 500 hit lows in the mid 600s to 700s. If I didn’t have the $2,000 to invest monthly because I moved out, then I wouldn’t have been able to ride the wave all the way up to the 1400s just a quick three years later which is over 93% in appreciation.
Plus dividends that I re-invested.
Would you rather have $72,000 averaged into investments over the course of 3 years and let it grow to fund your financial, professional, and personal life?
Or would you rather pay it to rent?
Also, it gets even more wild.
Let’s say I completely stopped dollar-cost averaging after those first 3 years. Where would I be in 2020?
The S&P has doubled to the 2800s, and hit a high of nearly 3400 in February 2020.
Do the math and I think living at home to set up my financial foundations was, and to quote Larry David, “pretty, pretty, pretty good”.
Ultimately though, you have to choose what works best for you, there is no right or wrong.
The whole point of my website is Freedom of Choice. You choose the path where you want to take your life.
I just want to set you up for as much financial and professional success as possible, so every little bit helps and that’s why I share my personal stories.
Sample diversified DCA index funds portfolio
Anyways, back to my initial dollar-cost averaging portfolio which as a reminder, it included a total US market index fund, international markets, and REITs.
I was only 22 then, so I knew that if the market tanked some more, I can always dollar-cost-average it down. I also had my whole financial future ahead of me.
But more than anything, I was pretty confident it would go up in the long-term because it had dropped so much.
I will also say that I have a pretty risky appetite and while some things like this one turned out great because of my moves here, there were plenty of times when it didn’t turn out so hot.
So understand your own situation and risk tolerance to make your own choices accordingly.
Don’t just blindly follow someone you’re watching through the computer screen or article you stumbled upon online…
Now, when you build out your own DCA investment portfolio, here are some examples. And remember, I’m legally required to say that this is not financial or investment advice. It is merely an example of what you can do:
- US stocks: VTI, SCHB
- Foreign stocks: VEA, SCHF
- Emerging markets: VWO, SCHE
- Dividend stocks: VIG, SCHD
- Corporate bonds: LQD, SPIB
- US government bonds: BND, BIV
If you want to spice up your portfolio with more risk, then you can add speculative asset classes like cryptocurrencies.
For example, take 1-5% of your total investment portfolio and buy some Bitcoin and Ethereum.
And of course, you always want to set aside cash, ideally in a high-yield interest savings account, for any emergencies that may arise.
An important tip when choosing your index funds
If you do invest in funds, one of the most important things to look for is called the Expense Ratio.
You want this to be low so that you can keep more of your gains and not pay so much year-over-year on expenses. These expenses really add up in the long-term and those extra fees you’re paying just because the manager is more “actively managing” the fund is rarely worth it.
As I showed previously, fund managers rarely outperform the market.
For example, let’s take an expense ratio of 1.2%. This means that whether you gain or lose for the year, you’re going to be paying that as a fee.
And if the fund only appreciates 1.5% for the year, you’re only pocketing 0.3%. The fund is pocketing the rest.
This goes against another video I posted where I say you have to pay yourself first. Paying yourself first is a defining principle for personal wealth and financial discipline.
One of the attractive aspects of dollar-cost averaging is that it is long-term, so you’re not worried about the short-term fluctuations and volatility. But if you’re paying that 1.2% expense ratio annually, that ends up being a lot of money that should have been in your pocket.
That is a big no-go in my books because there are far too many good choices for funds with low expense ratios where you can keep your gains and compound them year-over-year.
How to automate your dollar-cost averaging investing plan
So how do you set up your brokerage account to automate the dollar-cost averaging process? Here are your options:
- You can set a reminder on your own calendar to manually invest in the funds of your choosing at a set frequency, let’s say every week, every 2 weeks, or every month. This is what I did when I first started.
- You can instruct your brokerage to DCA for you.
- Finally, the easiest way to DCA is robo-investing on platforms such as Wealthfront.com. You simply sign-up, choose your risk tolerance level from 1-10, and the platform will automatically diversify your portfolio into a variety of funds with your scheduled deposits.
Easy peasy, fresh and breezy. Or what she said.
And that’s all I have for you for dollar-cost averaging.
If you’re interested in adding cryptocurrencies to your portfolio, then check out my video on it.
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I’m Alan, signing off and once again, helping you build your Freedom of Choice lifestyle. I’ll see you soon.