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What Does it Mean to Dollar Cost Average?
Investment in a security at regular intervals of a uniform sum regardless of the price level in order to obtain an overall reduction in cost per unitMerriam Webster dictionary
Dollar-cost averaging is a powerful but simple strategy of investing the same amount of money at a set frequency, regardless of market movements.
For example, you invest $1000 per month in your chosen portfolio for the next 10+ years.
The secret of building wealth through the stock market will be disappointingly boring to some, yet refreshingly simple for others. It is to invest consistently over a long period of time.
Sounds easy right? Yet most investors will either fail to invest as they planned (due to fearful media coverage or competing financial priorities) or withdraw money during market volatility.
Investing regularly and consistently means finding some other way to fund car repairs, replace a broken fridge and the other little emergencies that come up in life.
I thought this graphic from Fidelity demonstrates pretty powerfully why investors need to stay in the market and stick to the plan. You really don’t want to miss out on any of the best 5 days to invest in the next 40 years.
Why it is Useful to Dollar Cost Average
Most investors do not consistently invest for decades. Many jump in and out of the market, or stop and start. Many switch strategies frequently and take excessive risks.
Individual investors routinely and significantly underperform the market return, year after year. Factors contributing to this performance include over trading, incorrectly timing the market and overconfidence being the most significant.
But anyone who has read a few articles on finance and investing will know you should buy low, sell high, hold long term and aggressively minimise fees.
So why are these investors failing to keep up with market performance?
Let’s assume you are far more intelligent and knowledgeable than the “Average investor”.
Surely you can at least match market returns?
Yet even professionals routinely underperform a simple index.
What’s going on? Why can the vast majority of investors act irrationally?
Turns out we are hard-wired to be underperform.
1. Dopamine and Short-Termism
Dopamine is a chemical messenger (a neurotransmitter in the brain). It is released in response to delicious food, exercising and sex. It reinforces pleasure, reward and motivation.
Rats who had no dopamine release will not move a few centimetres to get food, and instead, starve to death!
Parkinsons disease is caused by a reduction in dopamine and is treated with an oral replacement (sort of) dopamine. As the disease progresses, Parkinson’s sufferers can hardly move within hours of missing their medication.
Occasionally, Parkinson’s sufferers become addicted to their medication, overuse it and show addictive behaviours (such as suddenly starting gambling).
There is a theory that inherent dopamine deficiency contributes to addiction, along with genetic and environmental factors. Our brains process short and long term rewards differently. We are biased towards short over term rewards.
Online stock brokers stuff their website full of data in red and green, updated every few minutes.
We know that investing for the long term whilst minimizing trading and fees creates better performance. So why do these stockbroker platforms think investors need minute by minute updates? Even for well researched individual share investors, surely the minute by minute price is irrelevant?
Your Classic Trading Platform is Design to Keep you Addicted to Trading
These platforms are designed to be addictive, just like social media. The longer an interface can keep you hooked, clicking, trading, and paying fees the higher the profits from the stock broker.
If the price goes up a dollar, we are rewarded with a hit of dopamine. When the price goes down a dollar, our mood can be dented, panic can set in and investments sold (resulting in another fee).
They encourage short-termism and take advantage of our natural tendency to value short term wins over longer-term bigger gains. As a result, the trading platform makes bigger profits, and investors trade away a lot of their returns.
2. Herd Behaviour
It’s incredible how our instincts subconsciously manipulate behaviour. Herd behaviour is the tendency for people to behave consistent with a group, even when the individual wouldn’t choose to behave that way outside of the group.
Have you ever chosen between restaurants for dinner and went with the busiest, assuming it must be better? This is an example of the Bandwagon effect. Individuals assume if a large group make a certain choice, they must have more information than the individual and are unlikely to be wrong.
A savvy restauranteur may invite a few passersby to a free drink in the restaurant to attract the crowd that follows the apparent popularity
We are also social animals. The instinct to be accepted by the group remains strong. It influences how people dress, what they drive and how they behave. It is instinctual to try and “fit in”.
Herd behaviour has a very dark side, believed to contribute to the mob mentality and violence of rioters.
Herd behaviour is a useful instinct in avoiding danger. In investing, herd behaviour exacerbates extreme stock bubbles and the consequent crashes.
The Good News – Using Herd Behaviour to Your Advantage
The good news is that you can overcome these biases. The first step is to be aware of them. It is useful to have a “herd” moving in the same direction you want to go!
If all your friends and colleagues are spending their cash on status symbols and think the stock market is gambling, it’s going to be even harder to delay consumer gratification and hold steady during market dips.
“You are the average of the five people you spend the most time with”Jim Rohn – Entrepenuer, author and motivational speaker
If you want to live a different life, less full of consumer purchases but more full of financial freedom, abundance, time and choice, it’s important to find a new “herd”.
Subscribe to Aussie Doc emails, listen to podcasts that you find motivating and join groups online that are full of people heading towards financial freedom, instead of away.
Look out for clues in “real life” for like-minded people and start a conversation about your favourite book/podcast/group.
Find habits to keep you on the straight and narrow. I find writing this blog helps me keep focussed.
The Good News – Dollar-Cost Average and Automate to Overcome Short-termism
Go out for a delicious meal, have great sex and enjoy some exercise. You don’t need a dopamine hit from investing.
Commit to dollar-cost averaging – investing a little bit every fortnight, month, or quarter. Increase your accountability by writing the goal down and sharing it with someone you trust – a partner, parent, sibling friend or mentor. Make a plan for what to do in an emergency, when you are short of cash and tempted to delay investing. Make a plan for when (not if) the market crashes and you feel tempted to withdraw.
Automation really takes it to the next step. If you have to log on to your computer (or phone) and press buy every fortnight, month or quarter there will be many opportunities to fail to invest.
If you really know that you need to stop your regular investment because of a true crisis, you will easily be able to stop the direct debit. Investors are far more likely to invest consistently if the investment is automated.
Dollar-Cost Average vs Lump Sum Investing
If you have a lump sum to invest because you have saved a lot, received a cash windfall or inheritance you need to decide whether to invest the lot at once or dollar cost average over a period of time.
The mathematically correct answer is to lumpsum invest. 66% of the time (according to Vanguard) investing a lump sum will achieve a better return than dollar cost averaging over a year. Because the market, over the long term, always goes up, the longer you delay investing the full lump sum the more returns you miss out on.
But many investors will be anxious about investing a large lump sum. If the day after they invest the market crashes by 50% investors need to know they can hold and tolerate the volatility. If lump sum investors panic and withdraw their lump sum after a crash, they will only have succeeded in losing a large chunk of your money.
So those with a lump sum, spend a week or two (max) working out what to invest in and either lump sum it or dollar cost average over a year or less.
How to Dollar-Cost Average
There are a few ways to dollar cost average your investments. Here we are purely talking about investing in the stock market.
If wanting to invest in property, you could to invest in a Real estate investment trust (REIT) listed on the stock market or through Brick X. By definition when you purchase an investment property directly, you are investing all the cash (including that borrowed by the bank) at the time of purchase, even though you pay it off over time.
Options to dollar cost average into the market
1. Invest Brokerage Free as Often as you Like but Pay a Management Fee
Investing using microinvestment apps like RAIZ generally have an ability to direct debit straight into investments. This is a very easy way to start dollar cost averaging, with a bit of money from each paycheque.
If you pay no brokerage you will generally pay a management fee – a set percentage of the total invested on an annual basis. These are currently $3.50 per month up to $15,000 invested, which seems pretty reasonable.
After this the fee becomes 0.275% this gets excessively expensive as your investments grow. Remember you pay the fee every year on an increasing balance, compounding the effects of the fees. Brokerage you sell once on purchase, and again when you sell.
The microinvestment apps are (including RAIZ) generally not CHESS sponsored. This means you don’t legally own the underlying investments but they are held in trust for you. This could be an issue if the provider closed. I personally didn’t mind this for a small balance, but don’t like this risk and would prefer CHESS sponsorship now my investments are more significant.
2. Invest less often, Pay Brokerage but no Management Fee
If you are paid fortnightly you are unlikely to want to pay brokerage every fortnight. You can open a separate account to save your “investment” to make investments regularly.
Working out how often to purchase investments to make the brokerage worthwhile involves estimating planned return and alternative return (from your money sitting in a savings account or offset.) Here is a link to a handy investing frequency calculator that can help you work it out.
If automation is important to you (and I feel it should be, see the problems with human brains above), I have found Pearler* an easy user-friendly way to automate investments.
Commsec Pocket also allows automated direct debit investments. This is a sort of a hybrid between the microinvestment apps and a brokerage. Commsec pocket charge no management fee, which is great. Their brokerage is $2 for $1000 investment. This is a similar cost ratio to Commsec but allows for much smaller investment amounts (perfect for paycheque investing). Unfortunately, the brokerage is still around double the cost of Self Wealth (that doesn’t have an auto-invest feature yet) or Pearler*.
3. Invest in Vanguard products Brokerage Free with Vanguard Personal Investor
I was about to start investing with Vanguard when the Vanguard personal investor commenced. I was pretty unimpressed with the new 0.2% management fee on retail investors as Personal investor was commenced. As a result I started my first investment with RAIZ, dabbled with Stockspot before opening a Commsec account and then switching to Pearler.
The good news is that Vanguard have significantly improved Vanguard personal investor. You can now invest in Vanguard products only brokerage free and without a management fee. Other ASX shares attract a $9 brokerage (excellent) and an annoying 0.1% annual management fee.
Many of my readers may only invest in Vanguard products so this may suit them perfectly. The one big issue remaining is the lack of automation. You have to press buy every week, month or quarter. Automation, for me, is a huge helper on keeping on track to goals.
Great news! Vanguard emailed me today (Nov 2021) a new auto-invest feature is now available on their managed funds. They remain brokerage and account keeping fund and you can invest from as little as $200 / quarter! This probably replaces the micro-investment app for many new investors and may last many investors through their investing career. Check out the offerings. (they have teased they may get auto-invest working with ETFs, but not yet).
4. Invest Brokerage Free via Superannuation
It is quite easy to direct debit each money into your superannuation with each pay. If you are not maxxing out your non-concessional limit of $27,500 per year (using salary sacrifice) the significant tax benefits should definitely be taken into consideration.
If saving1% in fees per year makes a massive difference to your investment returns over the long term, imagine what saving 15% in tax could do!
You do not pay brokerage fees for contributing to super, but there are obviously ongoing management fees.
I am pro-super. I’m over 40. It’s hard for those under 30 to fully appreciate the benefits, and tolerate the legislative risks that come with super. I would suggest everyone at least put some extra into super, maximising any “employer match” available.
Over 30, strongly consider investing up to your $27,500 concessional contribution cap.
The exception to this is if you are about to have a large increase in income. If you will breach your concessional cap within the next 5 years (~$275,000 gross “base” salary) you will be able to use catch up contributions for the first 5 years of the super high income to make up for not hitting the concessional cap in the years before.
In 2021 you earn $150,000 base pay and end up with $25,000 in total employer, salary sacrificed and voluntary contributions.
In 2022 you are promoted to the “Boss job” earning $250,000 base pay and end up with $30,000 in total employer and salary sacrificed concessional contributions.
Normally you would have to pay extra tax for the concessional superannuation contributions over $27,500. Instead of paying 15% tax on the excess super contributions of $2,500 you pay your marginal rate of 45%.
But because of catch up contributions, as long as your super balance is under $500,000 you will be allowed the excess as a “catch up contribution and only pay the usual 15% tax.
Non-concessional cap come in handy over 50 when your closing in on your preservation age and really need to maximise super to benefit from the tax free income stream after 60.
Human brains are designed to fail at investing! Use any mental trickery and handy tools you find useful to keep you moving closer to your goals.
Your wealth accumulation journey starts as soon as you make the first step.
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Aussie Doc Freedom is not a financial adviser and does not offer any advice. Information on this website is purely a description of my experiences and learning. Please check with your independent financial adviser or accountant before making any changes.