Wealth building is a process that comes in many forms. Many agree that there are three major steps to wealth building:
- Eliminating Debt
- Saving Money & Acquiring Assets
- Allowing Assets to Grow
If we were to equate wealth building to painting a picture, Step 1 would be our blank slate, Step 2 our paint brush and Step 3 our paint. While Eliminating Debt takes on its own form that is discussed in many different blogs on this website; both Saving Money and Allowing that Money to Grow must have a starting point, or a strategy for investing money so that it can grow.
There are two (quite obvious) ways to investing money:
- Invest at set intervals
- Invest at sporadic intervals
Let’s talk about investing at set intervals, better known as Dollar Cost Averaging (DCA). Chances are, you have been exposed to DCA, even if you did not know the terminology for it. Investopedia.com defines DCA as:
“The practice of dividing an investment of an equity up into multiple smaller investments of equal amounts, spaced out over regular intervals.”
Common avenues that utilize DCA include employer sponsored 401(k)s and other retirement investment vehicles that play into the defining DCA characteristic of set interval investing. DCA can also be practiced as an investor in taxable investments, whether they be stocks, index funds, bonds, or even real estate.
Here are the three main theories behind utilizing DCA, over sporadic lump sum intervals:
- Reduces the effects of short term volatility on investments
- Eliminates the risk of psychological short-comings when trying to “time” a lump sum investment
- Allows investing to be automatic
Let’s take a closer look at item #1. Reducing short term volatility allows an individual to maximize long term potential in a steady manner. Say you have a total of $12,000 a year to invest.
- Dr. A decides she wants to utilize DCA and invests $500 biweekly into an SP 500 index fund.
- Dr. B chooses the sporadic lump sum investment and tries to time the market $6000 at a time.
While there is a chance that Dr. B might get it right, there is an equal (and quite honestly) greater chance that he will get it wrong. Mathematically, market increases and drops will affect lump sum investor Dr. B more drastically than DCA investor Dr. A since she is spreading her risk over a longer and patterned period of time. Thus, Dr. A is reducing short term volatility.
Now let’s take a look at item #2. Market timing is a hotly debated topic, however the overwhelming scientific and mathematical conclusion is that it simply cannot be done effectively. Too much emotion takes place in market timing. Additionally, superfluous factors and biases from the media, the government and the water cooler conversation play a role in contributing to market timing uncertainty. Utilizing DCA allows an individual to circumvent “market timing nerves.” DCA ensures that emotion is taken out of investing and that large dips and peaks are average out.
Finally, let’s analyze item #3. Making investing automatic is a key aspect to creating passive wealth. Automatic investing prevents temptation to spend money or utilize it in an unproductive way. In fact, this is one of the big reasons for the creation of the 401(k). Realizing that many individuals retire with too little in funds, the 401(k) circumvents the human desire to spend by making the money unavailable for short term use in the first place.
So is DCA the method of investing for you?
Ultimately, that’s a question that requires an introspective look. More conservative, hands off investors prefer DCA due to the mathematical principles behind it, however if you have a stomach for risk taking then lump sum market timing may meet more of your needs. Neither method is technically “correct” and each present both pros and cons. Either way, the overlying principle of wealth building still remains: start investing now and continue to invest.