Congratulations! You’ve saved up a little money, and you want to start investing to put that money to work for you rather than vice versa.
You decide to start simple with a few index funds to spread your money among a diverse range of stocks. But before dumping it all into the market at the same time, you face a second question: Beyond what to invest in, when should you invest in it?
Most investors answer that question in one of three ways. You can invest in lump sums whenever you happen to come into money. You can “buy the dip,” timing your investments alongside market drops. Or you can spread your investments evenly over time through a strategy called dollar-cost averaging.
Note that these are long-term investing strategies, not short-term strategies like day trading and swing trading. Different principles and math apply to trading versus investing.
For long-term investors — especially casual, passive investors — dollar-cost averaging nearly always works out better than trying to time the market. Here’s why.
How Does Dollar-Cost Averaging Work?
Despite the complicated-sounding name, dollar-cost averaging is the easiest investment concept you’ll ever learn. It refers to investing the same amount into the same investments on the same recurring schedule to simply keep investing continually over time.
For example, imagine you save $300 per month specifically for investing (you already have an emergency fund saved). To keep things simple, you invest in three index funds: one for U.S. large-cap stocks, one for U.S. small-cap stocks, and one for international stocks.
Every month, you invest $100 in each of those three funds. The end.
You just keep investing on a regular schedule without trying to get fancy or time the market. By investing small amounts over time, you avoid the risk of putting all your money into the market right before a crash without missing out on upswings because you’re buying in gradually the whole time, no matter what the market is doing.
You can also dollar-cost average when you receive irregular or one-time payouts. Say you get a tax refund for $3,000 and you want to reinvest it to build wealth even faster. Rather than dump it into the market all at once, you adjust your monthly investments to spread it over, say, the next year. So instead of investing $300 per month, you invest $550, spreading that $3,000 into an extra $250 each month.
Keep in mind that you don’t have to invest a month’s worth of money all at the same time. I invest weekly, rather than monthly, to spread my investments more evenly. In the example above, that would mean investing around $70 per week instead of $300 per month. You might choose to invest weekly or every pay period — whatever schedule works for you.
Pro tip: Before you add any stocks to your portfolio, make sure you’re choosing the best possible companies. Stock screeners like Stock Rover can help you narrow down the choices to companies that meet your individual requirements. Learn more about our favorite stock screeners.
The Logic Behind Dollar-Cost Averaging
By dollar-cost averaging, you effectively mimic the movement of the fund or stock you’re investing in so you earn the same average return over time as that underlying investment.
That, in turn, eliminates emotion from your investments. That matters because emotion is the enemy of investing. Studies show that the average investor consistently underperforms the market as a whole, largely because they sell low when everyone else is panicking and buy high when everyone else is piling into the market. See this analysis from DALBAR showing that over a 20-year period, the average investor earned roughly half the returns that the S&P 500 as a whole delivered.
If that isn’t enough to convince you, consider the following reasons to dollar-cost average.
Reduce Risk by Not Trying to Time the Market
One of the most common financial mistakes made by high earners is trying to time the market. Smart people who are good at what they do tend to love a good opportunity to prove just how smart they are. Unfortunately, that very urge is what gets them into trouble.
There are many reasons not to try to time the market. For one, next month’s dip may still be higher than today’s pricing. So that smartypants who sits smugly on the sideline waiting to buy the dip often still pays more than the passive investor who dollar-cost averages the whole time.
Or how about the fact that markets aren’t rational or predictable? They move up and down not just based on economic fundamentals, but also on human emotion. Which says nothing of day traders and speculators impacting stock prices, or automated stop-loss orders that trigger larger selloffs.
Then there’s the opportunity cost of sitting outside the market, by missing out on dividend income and the magical math of compounding.
Consistent Investing Boosts Returns With Dividends & Compounding
Over time, the stock market returns an average of around 10% annually. But if you remove dividends, those returns drop to around 6%.
When you reinvest your dividends, it helps your returns compound on themselves. Most ETFs and mutual funds pay out dividends, which you can keep as income, or you can reinvest right back into more shares — shares that pay even more dividends and continue to grow in value over time.
By trying to time the market and waiting to buy a dip, you leave your cash sitting uninvested in savings until “the right time comes along.” All the while, it’s not earning dividends, not growing in value, and not compounding.
Passive Investing & Automation
It takes education and skill to pick individual stocks, to day trade, or to time the market with anything approaching an informed position. These approaches take considerable time — time spent in education, and then time spent in execution.
Alternatively, you can dollar-cost average on autopilot. With a robo-advisor or investment advisor, you can simply set up automated recurring transfers into your brokerage account, which they then invest for you based on your preselected funds or other investments.
No muss, no fuss, no time spent poring over the day’s market movements. You just build wealth in the background, while going about the more important daily life of your career, your loved ones, and your interests.
And no, that automation doesn’t have to cost you money. Many of the best robo-advisors are free, including SoFi Invest and Schwab Intelligent Portfolios.
The Alternative: Buy the Dip
If there’s a downside to dollar-cost averaging, it’s that it only delivers market average returns. By its nature, it involves mimicking the rise and fall of the market as a whole. If the market surges by 20%, you earn around 20%; if it falls by 10%, your investments fall similarly.
Some investors want higher-than-average returns. So they try to time the market by buying in when the market falls.
Buying the Dip in Bull vs. Bear Markets
In a bull stock market, stocks fluctuate up and down, but they trend upward over time. So within a bull market, buying the dip kind of makes sense. When stocks retreat a little bit, investors can potentially score a bargain. But that logic only applies in the context of a bull market, with stocks only retreating briefly before continuing their upward climb.
In a bear market, stocks still fluctuate up and down, except they trend downward over time, not upward. In a bear market, if you buy today’s dip, you may well find yourself with even lower prices tomorrow. And next week. And next month.
This brings us full circle back to the original problem with timing the market. In the moment, you never actually know when a bull market will give up the ghost and become a bear market.
Who’s to say if a dip will become a correction — a 10% drop from the prior peak — or a bear market? While market corrections tend to be short-lived, bear markets are not. Going back to 1950, stock market corrections took around four months on average to go from peak to trough, and another four months to climb back to the previous peak. Bear markets take far longer an average of 13 months to reach bottom, then another 22 months to reclaim the prior peak.
The Math of Buying the Dip
Eventually, the stock market has always recovered from bear markets. So wouldn’t that suggest that buying the dip could still work out for you, given a long enough time horizon for bear markets to recover?
Financial data scientist Nick Maggiulli ran the numbers to answer that question, analyzing 40-year total returns for both dollar-cost averaging and buy-the-dip strategies. For each year between 1920 and 1979, he analyzed returns for the following 40-year period, under each investing strategy.
In the dollar-cost averaging scenario, an imaginary investor would have invested $100 per month, every month, for that 40-year period. In the buy-the-dip scenario, the investor would set aside $100 each month in savings and invest all of the savings whenever the stock market dropped. Maggiulli even gave the investor perfect market timing, buying in at the absolute low point for each market correction.
Of those 60 different 40-year periods, dollar-cost averaging beat buy-the-dip in 70%. And that was with perfect market timing. When buy-the-dip investors missed the market bottom by even two months, they went from beating the market average 30% of the time to only 3% of the time.
That says nothing of all the hassle and stress of following the stock market’s every move. It’s exhausting trying to constantly prove you’re the smartest person in the room.
Core Investing vs. Fun Money
I’m not immune to indulging in a little investing vanity and trying to beat the market. But I’ve learned the hard way how expensive it can be.
So I created rules for myself. First and foremost, I committed to a simple core investing strategy, based on dollar-cost averaging with diverse index funds. More than 90% of my monthly savings allocated for stocks is automatically invested through my robo-advisor.
But I leave a little money in my savings account to invest as fun money when I feel — emotion alert! — like an opportunity exists in the market.
Fun Money Option 1: Buy the Dip
As long as the overwhelming majority of your investing capital gets invested responsibly based on your core investing strategy, you can play around with timing the market with a little fun money. The important point is that you only set aside fun money you don’t mind earning lower returns on or even losing altogether. Think of it like taking $50 into a casino to gamble away as an entertainment expense, rather than a serious investing plan.
On days when the market plummets by 5% to 10%, I typically buy some extra shares. When everyone else is panicking, I don’t mind playing the contrarian. It often works out well.
But not always. Which is precisely why I only do this with a little fun money on the side.
Fun Money Option 2: Pick Stocks
Want to prove you’re smart enough to beat the market at large? Learn how to pick stocks, rather than trying to time the market.
With detailed analysis, you can often identify undervalued stocks and beat the market. But it takes education, patience, skill, and time. Try the CAN SLIM method as one approach to picking stocks — and prepare to put in work.
You can also buy individual stocks’ dip. When a fundamentally sound company’s stock suddenly drops in the face of a PR stumble or some other snafu unrelated to their long-term earnings potential, I sometimes pick up shares. And I usually sell them again once they bounce back by 10% to 15%.
I don’t have the time or inclination to track individual companies over the long term, and I don’t want to have to follow them in the news or watch their market share. So I set up automated sell orders to get rid of them after the fickle public has forgotten why they ever sold and have bought back in.
Then I put the earnings back into my core investing strategy.
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Final Word
Despite the allure of trying to time the market, mathematically, it rarely works.
If you want to set aside a little fun money to play around with, go for it. Scratch that itch if you must, but do it with no more than 5% to 10% of your total savings earmarked for investing.
For your core investing strategy, stick with the boring, tried-and-true method of getting rich slowly with consistent, diversified investments. It’s not sexy, and you can’t brag to your friends about how you outsmarted the market, but it works.
What ultimately matters is meeting your long-term financial goals, like being able to retire one day, not how clever you were along the way.
Are you dollar-cost averaging? How have you automated your investments to reduce the temptation to time the market?
Source: moneycrashers.com
