When you are investing for a long-term goal, like retirement, you typically don’t have all the money you need to invest up front. For most people investing like this, a portion of each paycheck contributes to their goal and piece by piece, they grow their investment. This is a great way to reach a large savings goal, but raises a question about how to actually invest the money.
No one likes getting a bad deal. And watching a stock go down in price only days or weeks after you buy it feels like a bad deal!
This is why many people are tempted to hang on to their contributions, and keep them in cash until the market dips enough. Then, when the market reaches a bottom, people buy with all of their saved up cash.
We call this strategy, “Buying the dips”, and it doesn’t seem like a bad strategy, but let’s look at an alternative so we can compare.
What if you were just to buy every time you make a contribution? This is called dollar cost averaging. It’s very simple. You just pick a dollar amount (we can help with that!), and every month you invest that dollar amount regardless of what the market is doing.
With dollar cost averaging, you get the advantage of buying more stock when the market is down, and less when the market is up. This is because you are buying at a constant dollar amount, so when the price is low, the stock is cheaper and you are able to buy more!
When comparing these two strategies, buying the dip under-performs the dollar cost averaging over 70% of the time.1 And this assumes that the investor knows exactly when the bottoms are. But no one has perfect knowledge of what will happen.
Without this perfect knowledge, dollar cost averaging wins 97% of the time.1 A pretty clear victor!
Based on this, we recommend that you take advantage of the simplicity of dollar cost averaging, with the knowledge that even if you could call all the bottoms, you would still be behind.
But dollar cost averaging isn’t the best solution for every situation.
Take for example a situation where you have a large sum of money you intend to invest. Should you invest it all at once? Or should you spread your investments out over the next year or so (dollar cost averaging)?
The tables actually turn here. It might seem a bit odd, but dollar cost averaging is often worse then just investing all of the money at once. To put some hard numbers to it, you are better off investing everything all at once 80% of the time when compared to slowly investing your money over the next year.2
You might be asking yourself, “What if the market crashes immediately after investing all of my money?”. This is a possibility, but the numbers show that the best move is to invest right away, and you’ll be ahead most of the time.
When it comes to long term investing, dollar cost averaging is the way to go (this is what Previsio does by default for all of our plans). Even if you know when the bottom happens, you can’t do better most of the time. And no one, including the experts, know where the bottoms are.
But, when investing a lump sum, you want to invest it all at once. Dollar cost averaging in this case will hurt you most of the time.
Interestingly, both of these rules are driven by the same reason. Waiting for the dips to invest your money means that you will miss out on market increases while you wait. Similarly, if you spread out a lump sum investment over a year, a large portion of that money will miss out on increases during the year. Both miss out on potential upswings while waiting to invest.
Ever since the stock market started in 1817, the overwhelming trend has been up (roughly 8% every year). This means that there have been a lot more ups than downs over the market’s history, so it makes sense that you would miss out more often than not by waiting to invest.
So, don’t wait! Get in right away and rest easy knowing that you’ve made the best choice.
So you’re a master investor now! Or maybe you aren’t quite there yet. No matter, we recognize that investing doesn’t capture your whole financial picture. In order to take your personal finance game to the next level, you need a plan that not only helps you with investing, but with all of the other aspects of your financial life. That’s why we think personalized lifestyle planning is a great approach. By creating a plan that embodies your personal goals and current financial state, we can help you live your best life right now, while keeping an eye to the future.
Take us for a spin!