When we first began managing our own money, it was a nightmare. We’d read about an “exciting stock” that we thought would be the next Microsoft, and then we’d enter a full position (all of our cash obviously) as soon as the market opened. Then we’d actually sit there and watch the price tick up and down, all the while questioning if we made the right decision. At one point we entered and exited the same stock 3 times in a single week. This sort of behavior can be attributed to two things; stupidity and emotions.
Emotion Wreaks Havoc on Returns
There’s an excellent book on trading that was written back in 1923 called “Reminiscences of a Stock Operator” which is well worth a read. The main takeaway is that the key to being a successful investor is to take control of your emotions, mainly fear, greed, hope and your big fat ego if you work in finance. In order to do so, you need to set some rules and adopt some best practices. One of these is called dollar cost averaging.
When you are an investor, your timeline should be indefinite. Any other horizon starts to move towards speculation. The shorter the horizon, the more speculative the position becomes. When you have an indefinite horizon, then this makes your entry price largely insignificant. That being said, you still want to make sure you’re entering a position at a fair value and that you’re not overpaying too much for a quality stock. As Warren Buffett likes to say, it’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price.
How to Dollar Cost Average Stocks
One way to significantly reduce emotion when purchasing stocks is through using dollar-cost averaging which is an investment technique of buying a fixed dollar amount of stock at regular intervals, regardless of what the share price does. Some of you might be familiar with dividend reinvestment plans (DRIPs) which are really just a form of dollar cost averaging. With a DRIP, the dividends paid by a company are automatically used to buy additional shares, regardless of what the price happens to be at the moment.
When you decide to invest in a stock, never go pull the trigger and buy the full amount. Set up a recurring monthly purchase, then buy a portion of your position each month.
Let’s say you have $5,000 you want to invest in Johnson & Johnson. Instead of immediately buying $5,000 worth of shares, you might decide to enter your position over the next five months. On the first day of each month, you’ll buy $1,000 worth of JNJ shares at whatever price they happen to be trading at. That’s basically how dollar cost averaging works. You spread your purchase out over time instead of buying all your shares at once. This works exceptionally well for people who want to accumulate shares over a much longer time frame.
Let’s say you landed a decent job and you’re able to sock away a few thousand dollars every month. What you can then do is create a portfolio of dividend growth stocks using our Q-Score calculator (coming soon). You can then setup recurring purchases for 30 stocks at the beginning of every month. Since there are no longer any transaction fees for retail investors, and you’re now allowed to buy fractional shares, the whole thing becomes very easy. Simply buy $66 ($2,000 / 30) worth of each stock at the beginning of every month. In five years, you’ll have $4,000 in each stock and a portfolio worth $120,000. If that portfolio yields a modest 3%, you’re now receiving $300 in passive income every month. Keep doing that for a couple decades and you’ll be amazed just how much money you’ll be raking in.
The Benefits of Dollar Cost Averaging
Once you set that “dollar cost averaging” plan into action with specific dates to buy, you’ll find that all that stress about finding the correct entry point just evaporates away. If the stock goes up, you’re watching the shares you hold increase in value. Your ego tells you that you have done good by beating Mr. Market and the fact that you have to pay a premium now to buy shares doesn’t bother you that much.
On the other hand, if the market goes down significantly, you don’t like to see your position in the red, but that paper loss decreases every time you make a purchase. You’re also quite happy to be buying shares at a much cheaper price than you were paying before. Whether or not the stock price rises or falls – and all stocks rise and fall – you’re still going to be content. Now you can see how dollar cost averaging takes the emotion out of the trade.
Plenty of academics have argued as to whether or not dollar cost averaging outperforms market timing. In other words, some say that it’s better to just get into your position sooner. It’s about time in the market, not timing the market. We would argue that even of dollar cost averaging doesn’t perform any better than trying to time the market, we would much rather choose the method that helps us sleep well at night. When you’re able to remove the emotion from a trade, you’ll definitely reduce some stress.
Advanced Techniques
Dripping It
One technique to supercharge your dollar cost averaging strategy is by also choosing to DRIP your stocks. Most brokerage firms will have an option next to each of your stocks that pay dividends which says “reinvest dividends.” Some companies even allow you to reinvest dividends with a discount which is essentially free money. So in addition to the amounts you’re buying every month, the dividend checks will also be purchasing small amounts of shares at random times which helps reduce market timing and increases the size of your positions over time.
Timing the Market
Just because you’re using dollar cost averaging doesn’t mean you can’t do a little market timing. If after a bad earnings call you think a stock is a bargain, then sock some money into it from your savings. You can also change the amounts you’re investing up or down, or even reduce the duration of your schedule. If you think a stock is richly valued, just increase duration by reducing the amount. Ideally, you want all your stocks to be roughly the same position size, so that means you’ll need to increase the amount you invest at a later point in time.
We’re often tempted by dips in stocks we’re trying to accumulate, and may pull the trigger on larger monthly buys when we think we’re getting a bargain. This is speculating. Sometimes it works, sometimes it doesn’t. The point is that there are trillions of dollars in institutional money that regularly look at the markets and analyze whether to buy or sell a stock. In the majority of cases, they get it wrong. Don’t think that your part time stock research conducted over the weekends in your underwear is going to outperform those people who do this stuff for a living.
Our Own Portfolio
We “work in finance” and still have zero advantage over anyone else when it comes to timing the market (i.e. deciding when to buy and sell). Instead, we try and use objective methods like dollar cost averaging, Quantigence Q-Scores, and the basic rules of diversification to remove as much emotion as possible from our investment decisions. We spent about a decade accumulating 30 different positions each month for our 30-stock portfolio using dollar cost averaging. Today, we’re enjoying a growing stream of dividend checks that provide a better quality of life each year that passes.
Don’t listen to your ego telling you that you somehow have an information advantage over the millions of other investors out there, most of whom are more informed and have better access to institutional data than you do. Simply use “dollar cost averaging” and sleep better at night. You’ll thank us for it.
