 Personal Finance Powerpoint Presentation, Dollar Cost Averaging. Prepare to get financially fit by practicing personal finance. Most of this information comes from Investopedia Dollar Cost Averaging, which you can find online. Take a look at the references, resources, continue your research from there. This is by Adam Hayes, updated July 27, 2022. In prior presentations, we've been looking at investment goals, strategies, tools, keeping in mind the two major categories of investments, that being the fixed income, typically bonds, the equity, typically the common stock. And also keep in mind the tools you're using, which might include things like mutual funds, ETFs, which are going to help to pool the investments together to help to diversify your investments, where you might be using a little bit different strategies than if investing in individual stocks, in which case you might be drilling down on the financial statements of those particular stocks, doing a ratio analysis and trend analysis on them. Keeping that in mind, asking the question, what is dollar cost averaging? Investing can be challenging. Even experienced investors can try to time the market to buy at the most opportune moments, can come up short. So even if we're a long term investor, if we're kind of holding onto our money and trying to determine when the best time to put the money in can be kind of a burdensome situation, because of course we'd still like to put the money in when it's a bargain or at the trough, when it's a good time to be purchasing. Dollar cost averaging is a strategy that can make it easier to deal with uncertain markets by making purchases automatic. So we might try to eliminate the stress, for example, in some way by making some routine type of investments. And we're basically saying, hey, look, I know there's going to be increases and decreases in the markets. I'm going to win some. I'm going to lose some. Maybe it's not worth my time to try to out guess when the most opportune time is to invest, but rather spread my investments out as a long term investor and put them in on kind of a more standard kind of format. So it also supports an investor's efforts to invest regularly. This could be quite good regular investments that is for people that are working like another job or something like that. And they don't have a full time job of basically timing when the best time is to invest and making the regular investments can be a better way to go oftentimes in that scenario. Dollar cost averaging involves investing the same amount of money in a target security at regular intervals over a certain period of time, regardless of price. By using dollar cost averaging, investors may lower their average cost per share and reduce the impact of volatility on their portfolio. That being, of course, the fluctuation in the stocks, the volatility. In effect, this strategy eliminates the effort required to attempt to time the market to buy at the best prices. So in other words, if you don't have like an automatic strategy to put into the market, then oftentimes you might be like looking at your stocks from time to time, possibly once a week or once a month or something like that. And then you're asking yourself, well, now I've got a pile of money that's been piling up, for example, that I plan on investing, but I'm not sure if I should put that lump sum in at this one time. The more money you put in at one time, the more risk there is or the more beneficial it would be to have the opportune time to put the money in as opposed to putting money in periodically then each individual investment is not going to have as much of an influence and you're going to be a long-term investor in any case or possibly that's the assumption that I am making here if you're investing for retirement, so it should work out in the long run. So dollar cost averaging is also known as the constant dollar plan, how dollar cost averaging works. The dollar cost averaging is a simple tool that an investor can use to build savings and wealth over the long term. So remember, if you're investing for retirement or something like that, you're a long-term investor typically if retirement is out in some place out into the future. So keep that in mind with your strategy. It is also a way for an investor to ignore short-term volatility in the broader markets. So if you're a long-term investor then oftentimes you don't want to have too much on the headaches from the short-term volatility because you're assuming that the short-term volatility if I zoomed down in the graph it might be doing something like this but if I zoomed out in the long-term then those spread out and you get hopefully more of an even kind of growth thing. I'm focused here on the long-term not on the short-term dips and troughs although I would still like to be buying at the trough if I had to be able to choose between them but instead of doing that we're going to basically just put our money in intervals and then let the fact that we're a long-term investor kind of work things out over the long run. A prime example of long-term dollar cost averaging is its use in 401k plans in which employees invest regularly regardless of the price of investment. So when you put money into the 401k plan you're probably not thinking too much. You're just saying, hey, I'm committed to the strategy. I'm going to put the money in according to the strategy. I'm going to let it ride because in the long run hopefully it'll be good to go. So with a 401k plan employees can choose the amount they wish to contribute as well as those investments offered by the plan in which to invest. Then of course they get taken out of your wages automatically which is kind of what you want to do. You want to set a plan that kind of works for that long-term investment and then let it ride and that hopefully will prevent you from making short-term decisions based on emotions where you're usually not predicting well in the market when you're basically basing your picks on fear and allow you to hopefully keep a good strategy in place for a long time where of course hopefully it plans out in the long run. So then investments are made automatically every pay period. Depending on the markets employees might see a larger or smaller number of securities added to their accounts. Dollar cost averaging can also be used outside of 401k plans. For instance investors can use it to make your regular purchases of mutual or index funds. So you can do the same thing if you don't have the 401k plan or outside of the 401k plan and just use index funds for example and put some money in from time to time. The index funds and mutual funds using a strategy of investing in the market more broadly as opposed to picking basically individual stocks. Whether in another tax advantage account such as an IRA so if you don't have a 401k plan you could try to get some tax savings by putting it under the umbrella of an IRA or taxable brokerage account. The thing to remember here and the thing that many people really just don't get to explain this to a lot of people they think that when you're investing that you have to be that there's some big difference to investing in a 401k plan an IRA versus just investing in mutual or index funds outside of a 401k plan or an IRA. There's not a big difference other than the taxes. The only reason you're still investing typically when you're investing in a 401k plan or an IRA in the underlying investments are typically mutual funds often index funds which are kind of average funds that take less management by the management of the fund. So they're still in those index funds but then you can think of them under the umbrella of a 401k or IRA. Why would you put them under the umbrella of a 401k or an IRA? Because you get a tax benefit otherwise you wouldn't do it because it's a restriction. You can't take it out early. The government forces you to keep it in there in exchange for the tax benefit but if they didn't give you that tax benefit or if you wanted to put money outside of a 401k over an IRA because you want to have access to it before retirement without getting penalized then you could still use the same strategy because you're still using basically mutual funds and index funds and you might want to put money in there periodically in the same way. Dollar cost averaging is one of the best strategies for beginning investors looking to trade ETFs or mutual funds. Additionally, many dividend reinvestment plans allow investors to dollar cost average by making purchases regularly. So clearly when you're starting out if you're not trying to beat the market, you're a long-term investor then you might use a strategy such as this, use your 401k plan, use a mutual fund or an index fund where they can also have some of the earnings from those funds, the dividends in other words rolling back into the fund instead of being distributed to you and that could be another strategy to help grow the fund hopefully in a diversified and as safe as possible way over a long time horizon which is typically thought to be one of the better strategies for long-term investment and growth for things like retirement. Benefits of dollar cost averaging. Dollar cost averaging can lower the average amount you spend on investments if it reinforces the practice of investing regularly to build wealth over time and notice that wealth over time like saving for retirement, that's a long-term habit. Remember that individuals are not as good as a theme of the course here. Individuals are good at short-term decisions. If you put a problem in front of an individual if it's causing someone pain in the current circumstance they'll figure a way around it. But long-term is more difficult. So the way to deal with those long-term things is to plan a strategy out and try to make that strategy a more automatic strategy so that you don't have to rethink about it every time you put the money in. You can think about it thoroughly one time and then execute the strategy hopefully automatically so you don't have to think about it. It's automatic and can take concerns about when to invest out of your hands. It removes the pitfalls of market timing such as buying only when prices have already risen. Again, that's a huge kind of thing again because for individuals that have a whole lot of other things going on and they're not investors as their profession then you can agonize over changes in the markets and you can agonize over when you should put more money into the market. Believe me, I agonize over these things and you probably may not be worth it for many people to agonize over these things if you're a long-term investor because you could put money into a fairly simplified plan using a diversified portfolio through like index funds, mutual funds, and ETFs and then just execute your plan which is to keep on investing periodically and over the long run that theoretically that should work out better than you being able to figure out in the short run what's going to happen for most investors because you're not really betting on individual stocks but on the market as a whole and if the market as a whole bombs over 30 years then you probably couldn't outpicked it anyways because you're doing a diversified portfolio investing periodically over a long time frame. So it can ensure that you're already in the market and ready to buy when events send prices higher. It takes emotion out of your investing and again the emotion for individual investors is something that if we're not trained on it just like anything it actually oftentimes causes us problems. Emotions are good when the tiger is in front of us and we have to actually run from it. Other than that the fear that we have from investing or something like that often leads us to the wrong decision in a panicked situation either to buy more or sell more at that point in time. I'd like to eliminate the emotional purchases and purchase and sell based on a system that makes sense over the long term. So it takes emotion out of your investing and prevents you from potentially damaging your portfolio's returns. Who should use dollar cost averaging? The investment strategy of dollar cost averaging can be used by any investor who wants to take advantage of its benefits which include a potentially lower average cost of automatic investing over regular intervals of time and a method that relieves them of the stress of having to make purchase decisions under pressure when the market is volatile. Dollar cost averaging may be especially useful to beginning investors who don't have yet have the experience or expertise to just the most appropriate moments to buy. It can also be a reliable strategy for long term investors who are committed to investing regularly but don't have the time or inclination to watch the market and time their orders. However, dollar cost averaging isn't for everyone. It isn't necessarily appropriate for those investing time periods when prices are trending steadily in one direction or the other. So if you think there's like a broad, like you think everything's going into recession and there's extreme changes in the overall market, for example, be sure to consider your outlook for an investment plus the broader market when making the decision to use a dollar cost averaging. Special considerations. It's important to note that dollar cost averaging works well as a method of buying an investment over a specific period of time when the price fluctuates up and down. If the price rises continuously, those using dollar cost averaging end up buying fewer shares. If it declines continuously, they may continue buying when they should be on the sidelines. So the strategy cannot protect investors against the risk of declining market prices. Like the outlook of many long-term investors, the strategy assumes that prices, though they may drop at times, will ultimately rise. Again, the assumption is kind of like, well, in the short term, you're going to see a lot of this going on. But in the long term, if you zoom out of the chart, hopefully you get a graph that's going up over the long term and you're going to try not to worry about the zoomed in peaks and troughs, not get too emotionally drawn into those, hopefully, because you've got that long-term orientation. And again, you could veer from that strategy from time to time. If you think there's severe fluctuations in the market or something like that, but you've got to be careful of doing that because it's likely that when you do that, you start making decisions that are actually at the worst time in the market because that's when everybody's making those kind of decisions. So in this case, using this strategy to buy an individual stock without researching a company's details could prove detrimental as well. That's because an investor might continue to buy more stock when they otherwise would stop buying or exit the position. For less informed investors, the strategy is far less risky when used to buy index funds rather than individual stocks. And that's the common kind of thing here. Notice that if you had a 401k plan and that 401k plan was investing just in the company that you're in, that's a little bit risky because now your stock is in one company, for example. What you want usually when you use a strategy like this is to use some kind of mutual fund, which is going to have a diverse portfolio within the fund that you're investing in, possibly even an index fund, which could lower the costs of the fund management itself because you're just betting on the market as a whole as opposed to an individual stock. And that's often a method you might use when doing this. So investors who use a dollar-cost averaging strategy will generally lower their cost basis in an investment over time. The lower cost basis will lead to less of a loss on investments that decline in price and generate greater gains on investments that increase in price. Example of a dollar-cost averaging. Joe works at ABC Corporation and has a 401k plan. He receives a paycheck of $1,000 every two weeks. Joe decides to allocate 10% or $100 of his pay to his employer's plan every pay period. So he's going to put money directly out of his wages into the good old 401k plan, which you would think would be invested in something like mutual funds, for example, diversifying the portfolio with those types of tools under the umbrella of the 401k plan that he put it into because he got a tax advantage about it, as well as possibly some sharing from the employer. So he chooses to contribute 50% of his allocation to a large cap mutual fund and 50% to an S&P index fund. So he's putting it into these funds, a mutual fund and an index fund. So an index fund is a fund that's kind of like an average fund that has less management because it's going to be tied to an index and a large cap mutual fund, which doesn't say it's an index fund, so it might have more leeway for the manager of that fund to be invested around. It's pooling investments together for multiple investors. Every two weeks, 10% or $100 of Joe's pre-tax pay will buy $50 worth of each of these two funds, regardless of the fund's price. The table below shows the half of Joe's $100 contribution that went to the S&P 500 index fund over 10 pay periods. Throughout 10 paychecks, Joe invested a total of $500 or $50 per week. The price of the fund increased and decreased over that time. The results of dollar cost averaging. Joe spent $500 in total over the 10 pay periods and bought 47.71 shares. He paid an average price of $10.48, 500 divided by the 47.71. Joe bought different shares amounts as the index fund increased and decreased in value due to the market fluctuation. In other words, the market's going to fluctuate, so he's putting his money into an index fund. The index fund and the mutual fund are basically buying a bunch of different stocks within under the umbrella, allowing him diversification. But the cost of those funds at each given paycheck time when he buys them will differ. So he's putting a stable amount in investment, but each time he invests, he's getting a different amount of the stocks or the funds due to the fact that the stocks and funds are changing their price based on the market at any given time that the purchase takes place. The results of Joe spent one lump sum. So say that instead of using dollar cost averaging, Joe spent $500 at one time in pay period four. So let's say he just kind of says, I'm going to figure out my investments once a month. So at the end of the month, I'm just going to pick up my investment instead of doing it automatically and invest at that time. So instead of weekly, monthly, he paid $11 per share. So that would have resulted in a purchase of 45.45 shares, 500 divided by 11. There was no way for Joe to know the best time to buy by using dollar cost averaging, though he was able to take advantage of several price drops despite the fact that the share price increased over $11. So in other words, he could have came out better or worse by using the month end strategy, but by just investing every paycheck, he's going to buy some of the peaks and some of the troughs and he's not going to try to outpace the market. If he just does it at the end of the month, then he didn't take the peaks and troughs. He's investing basically at a later time, a little bit later time as well. And you could find yourself stuck in some situations where you're saying, hey, look, it looks a little too high of price right now. And therefore you start holding on to your investment in that way too. And again, it caused you a little bit more stress because now you're trying to make a physical choice as to when would be the best time to put the money in the market instead of just saying, I don't know the best time. I'm going to put it in periodically, more periodically. So I have both the increases and the decreases I'm putting money in. So he ended up with more shares, $47.71 at a lower average price, $10.48. So here's the table that you could take a look at in that if you so choose. A dollar cost averaging a good, is it a good idea? Is dollar cost averaging a good idea? I mean, it can be when dollar cost averaging, invest the same around at regular intervals by doing so, hopefully lower your average purchase price. You will already be in the market when prices drop and when they rise. For instance, you'll have exposure to dips when they happen and don't have to try to time them. By investing in fixed amounts regularly, you will end up buying more shares when the price is lower than when it is higher. So why do some investors use dollar cost averaging? The key advantage of dollar cost averaging is that it reduces the negative effects of investor psychology and market timing on a portfolio. It gives you less stress. You might keep a couple more hairs up there on the good old top of the noggin of your head. By committing a dollar cost averaging approach, investors avoid the risk that they will make counterproductive decisions out of greed or fear, such as buying more when prices are rising and panic selling when prices are declining. You're usually not going to do that well if you're not very experienced in it. You're going to do it out of fear. That means you're going to do it when everyone else does it and that means you're going to do it at the wrong time. Instead, dollar cost averaging forces investors to focus on contributions a set amount of money each period while ignoring the price of the target security. How often should you invest with dollar cost averaging? With regard to actually using the strategy, you often use it may depend on how investment horizon outlook on the market and experience with investing. If your outlook is for a market in flux that will eventually rise, then you might try it. If a persistent bear markets at work, then it wouldn't be a smart strategy to use. I mean, if you think there's long-term trends that are going on the downside, then again, you could take some strategies and differentiate up your strategies in those cases. But the general idea is, again, you're a long-term investor, so you're going to just keep investing and hoping the long run, it's going to basically turn out good for you. If you're planning to use it for long-term investing and wonder what interval for buying makes sense, consider applying some of every paycheck to regular purchases. So, obviously, that will differ depending on your pay, but that would be the easiest thing to do. And most people, that would be either weekly, semi-weekly, semi-monthly, I mean bi-weekly, semi-monthly, or something like that, or possibly monthly.