Dollar-cost averaging versus lump sum investing does work, just not in the way you think
It’s a good bet you’ve heard of the dollar-cost averaging strategy. Then again, it’s also a good bet you’ve heard some bad advice on how to use it.
The strategy of buying more stocks instead of just one lump sum investment can be extremely dangerous if you follow one of the biggest myths out there.
In fact, we recently saw one investor that lost nearly $30,000 from the bad dollar-cost averaging myth!
Used right and dollar-cost averaging versus lump sum investing can put you out way ahead…you just have to know how to do it.
The Dollar-Cost Averaging Myth that Could Destroy Your Nest Egg
Most investors think of dollar-cost averaging as a way to reduce their losses in a stock. Look at this dollar-cost averaging example and how it can all go bad very quickly.
- You buy $1,000 of stock in McDonald’s at $115 each
- Someone drops some lava-hot coffee in their lap and sues the company…shares fall to $80
- If you liked it at $115 then you must love it at $80 so you buy another $1,000
- A competitor starts selling breakfast and shares fall to $70 each
- Now you’re down over $500 – but if you dollar-cost average down even more then your average price is $87.45 per share. You’ll be sitting on a big gain if the stock rebounds…so you buy more.
I’m not saying McDonald’s isn’t a good long-term investment but you can see how the strategy can get out of hand. My investor friend that lost $30k got trapped in the worst dollar-cost averaging myth investing in coal stocks.
The problem is that you don’t know how far you will be chasing a stock down. Dollar-cost averaging can be like catching a falling knife because it can REALLY hurt if the stock keeps falling.
There’s a point where you’ve put so much money into a single stock that it dominates your portfolio. If the company goes bankrupt, as did many coal companies last year, then your entire nest egg can be destroyed from dollar-cost averaging.
How to Use Dollar-Cost Averaging versus Lump Sum Investing
Dollar-cost averaging does work though and we’ll prove the strategy in an example below. The way to use dollar-cost averaging correctly is by using it across your entire portfolio of stocks.
Instead of buying more shares of just one stock when the price goes lower, buy your entire portfolio regularly.
Uh, just a minute…that’s just regular investing? Yeah, it is.
Since nobody really knows when stocks are going to rise or fall, your best dollar-cost averaging strategy is just to regularly invest more money in everything you own.
There’s a warning here. You want to deposit savings into your investment account every month but you shouldn’t invest that money every month. Investing small amounts in different stocks every month is going to kill your returns by spending hundreds in fees.
Instead, let your cash balance add up and buy stocks every three- or six-months. You’re not going to miss any huge market opportunity and you’ll cut down on the money you pay in fees.
The best way to dollar-cost average with this strategy is to create a fund of your stocks on Motif Investing. The investing website allows you to group up to 30 stocks together and buy them all for one commission. That means you can dollar-cost average every few months, investing across all your stocks, for just $10 each time…compared to spending hundreds on any other site.
I use Motif for my own portfolio and highlight my stocks and funds here.
A Dollar-Cost Averaging Example that Proves the Strategy
Still not convinced? How about a dollar-cost averaging example? Compare a $5,000 lump sum investment ten years ago against dollar-cost averaging just $50 a month over the period. Both investing strategies are put in the S&P 500 stocks and let to run.
You would have $314 more in the dollar-cost averaging strategy versus lump sum investment. Best yet, you didn’t have to come up with $5,000 all at once and you probably wouldn’t have freaked out when the stock market crashed in 2008.
At this point, you’re thinking, “Well yeah, investing slowly instead of all at once at almost the height of the housing bubble isn’t a fair comparison. What about other times?”
Actually, take the investing period out longer in our dollar-cost averaging example and the benefit to the strategy becomes even bigger. Investing $5,000 in the stock market 15 years ago in 2001 would give you just over $12,766 today. Investing just $50 a month over that period would have grown to $18,300 – you would be up more than $5,500 on someone that just made a lump sum investment!
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Dollar-cost averaging does work against a lump sum investment strategy but you have to do it right. More than a few nest eggs have been lost on the biggest dollar-cost averaging myth and chasing a stock lower. Invest your money regularly whether stocks go higher or lower and you’ll come out way ahead to reach your investing goals!