The beauty of dollar cost averaging

Because it's Friday. And I'm going to cover some investing fundamentals. But you knew that.

wooden block letters spelling DCA

Image Source: Getty Images

You’re reading a free article with opinions that may differ from The Motley Fool’s Premium Investing Services. Become a Motley Fool member today to get instant access to our top analyst recommendations, in-depth research, investing resources, and more. Learn More

We had a team meeting this morning. We were discussing how to make sure our readers and members were best equipped to use our advice.

Spoiler: some of the people who get grumpy with our advice are those who, ahem, don't actually follow it.

For example, we say: "Buy at least 15-25 stocks, over time, to benefit from diversification".

And we say: "We try to be right as often as we can, but even the best stockpickers are wrong an uncomfortable proportion of the time. Usually being right 6 or 7 times out of 10 is enough to deliver a market-beating result".

And we say: "We're long term investors, aiming to beat the market over 3 to 5-plus years".

But, well, when we get some of the more searing pieces of 'free character assessment', they tend to be along the lines of "What about [Company X]? I bought it six months ago, and it went down, and I lost money because of you".

(Yes, seriously. That's not a verbatim piece of feedback but it's very representative.)

Now, it's true that you can lead a horse to water, but you can't make it drink.

But also, you can do your best to entice it to drink. And, for my sins, that's what I spend a lot of my time and effort doing.

(No, not actually making a horse drink. It's a metaphor. For investing. Anyway, moving on…)

It's why I write these articles. It's why I appear on TV, radio, and online.

It's why we have a podcast, called Motley Fool Money.

And it's why I'm going to do a semi-regular series, in this space, that I'm calling Friday Fundamentals.

(Because it's Friday. And I'm going to cover some investing fundamentals. But you knew that.)

Also, I'm resisting the urge to talk about 'putting the fun into fundamentals'. Because, that's cringe, as the kids say. Right?

I'm going to kick it off with one of the clunkiest phrases (but most important concepts) in investing: 'dollar cost averaging', or DCA.

As a descriptor, it's both 100% accurate and completely useless. There is almost no way you could know what I was talking about unless you'd heard it before, or someone explained it to you.

So… I'm about to do the latter.

Not by explaining the derivation of the description. That's doable, but boring.

I'm just going to tell you what it is by describing the actions it refers to.

See, investing is hard. For a lot of reasons. Some mathematical, and some emotional.

How much is a company worth? Is this a good price? What if I invest today and the shares fall tomorrow? How will I deal with a volatile share price?

One of the ways to address all of those questions is by dollar cost averaging.

In short, it simply means investing small amounts, regularly.

And it has some wonderful benefits.

First, it creates a great habit. Buying more shares each payday, or on the first of each month, or every 6 weeks (the frequency doesn't really matter, as long as it's not too long between drinks) means you don't use the money for something else, instead!

Second, it reduces the stress and risk of making fewer, larger investments. Investing $500 per month means fewer implications, per trade, than investing $6,000 once a year. It's easier, and cheaper, to change course, if necessary.

Third, it makes diversification easier. In our example, you could, for example, buy twelve different $500 investments across the year. (Yes, you could simply split your $6,000 into twelve when you invest that lump sum, but trying to find and analyse 12 different Buy ideas at once is a decent cognitive load… and time sink!)

Fourth, it puts the money to work more quickly. The market tends to go up, over time. So, mathematically, that same $500, invested now, is likely to start earning returns, rather than leaving it in cash until you had, say, $6,000 in a year's time. (No guarantees, by the way – some years it'll go down. But history suggests earlier is better, on average.)

Fifth – and this is the kicker, for me – it takes all of the stress out of trying to 'time' your purchases. But not only that, you get to take a psychological win, no matter what happens next!

Because one of these two things will happen:

1. You invest $500. The shares go up before your next $500 investment, so yes, you'll pay a little more next time. But, those initial shares have made you money, soothing the psychological pain of having to pay more.

OR

2. You invest $500. The shares go down before your next $500 investment, so you lost some money (in the short term at least). But, the next investment is made a that lower price, so you're getting a better price, and you can buy more shares with the same $500.

Yes, those are just little self-deceits. But we're human. A mix of biology and emotion. For many people, that two-part framework makes the whole investing thing easier to tolerate. Either way, you can bank a little psychic victory.

And so, you now know all about dollar cost averaging! Yes, the description is still as clunky, but we can't have everything.

Now, go forth and multipl… I mean average!

(By the way, if you have a question or suggestion for a future Friday Fundamentals article, please feel free to let me know!)

Fool on!

Motley Fool contributor Scott Phillips has no position in any of the stocks mentioned. The Motley Fool Australia's parent company Motley Fool Holdings Inc. has no position in any of the stocks mentioned. The Motley Fool Australia has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Scott Phillips.

More on Motley Fool Take Stock

surprised shopper, unexpected news, person at computer with payment card,
Motley Fool Take Stock

Afterpay increasing credit limits… what could go wrong?

At the risk of being called Grandpa, I’m from the ‘spend what you can afford or have already saved’ camp.

Read more »

a man sits at his computer screen scrolling with his fingers with a satisfied smile on his face as though he is very content with the news he is receiving.
Motley Fool Take Stock

I wish I'd known this decades ago

What would I tell my younger self?

Read more »

A little girl wearing a gold crown sulks and pokes her tongue out.
Motley Fool Take Stock

Alchemy? Nah, Fool's gold, instead!

We hope you enjoyed our little joke.

Read more »

A man in a suit smiles at the yellow piggy bank he holds in his hand.
Motley Fool Take Stock

Why are bank shares up so much?

While we can speculate on the answer, I’m not sure the speculation is useful.

Read more »

Model house with coins and a piggy bank.
Motley Fool Take Stock

'Housing AND Super', not 'Housing OR Super'

Yeah, but a home is more important than super, right?

Read more »

A man wearing thick rimmed black glasses and a business shirt with red suspenders sits at his desk sorting through the earnings report of Nickel Mines
Motley Fool Take Stock

One big lesson from earnings season

There is a lot to take in.

Read more »

Australian notes and coins surrounded by a calculator and the word super spelt out.
Motley Fool Take Stock

A simple fix for superannuation

It's time to return Super to its original purpose, to remove the complexity and to stop it being used as…

Read more »

Legendary share market investing expert and owner of Berkshire Hathaway Warren Buffett
Motley Fool Take Stock

Buffett's latest thoughts on business, investing and Berkshire

Whenever Warren Buffett speaks, or writes, I pay attention.

Read more »