At some point in your life you may find yourself in the happy dilemma of having a large chunk of cash to invest. An inheritance perhaps, or maybe money from the sale of another asset. Whatever the source, investing it all at once will seem a scary thing as 5 dollar stocks to invest in discussed in Part XVIII.
If the market is in one of its raging bull phases and setting new records each day, it will seem wildly overpriced. If it is plunging, you’ll be afraid to invest not knowing how much further it will fall. You risk wringing your hands waiting for some clarity and, as you should know by now, that will never come. The idea being, should the market tank, you will have spared yourself some pain. I’m not a fan of this strategy and will explain why shortly, but first let’s look at exactly what dollar cost averaging is. When you dollar cost average into an investment you take your chunk of money, divide it into equal parts and then invest those parts at specific times over an extended period. 120,000 and you want to invest in VTSAX, the total stock market index fund we’ve been discussing throughout this Series.
Now having read this far in it, you know the market is volatile. It can and sometimes does plunge dramatically. While unlikely, that would make for a very miserable day indeed. 120,000, let’s say the next 12 months.
That way, if the market plunges right after your first investment you’ll have 11 more investing periods that might perform better. This does eliminate the risk of investing all at once, but the problem is that it only works as long as the market drops and the average cost of your shares over the 12 month investing period remains on average below the cost of the shares the day you started. Should the market rise, you’ll come out behind. Assuming you were paying attention while reading the earlier Series posts, you know that the market always goes up but it is a wild ride and no one can predict what it will do in any given day, week, month or year. The other thing to know is that it goes up more often than it goes down. Consider that between 1970 and 2013, the market was up 33 out of 43 years. By dollar cost averaging you are betting that the market will drop, saving yourself some pain.
With each new invested portion you’ll be paying more for your shares. When you DCA you are basically saying the market is too high to invest all at once. In other words, you have strayed into the murky world of market timing. Which, as we’ve discussed before, is a loser’s game. DCA alters your asset allocation strategy. Unlike stocks, the cash you have waiting to invest is not earning dividends.