WALKING UP THE ESCALATOR: HOW DOLLAR COST AVERAGING TAKES THE GUESSWORK OUT OF INVESTING
April 21, 2016Follow Networthy on Twitter
I haven’t written too much about stock investing here on Networthy yet, which is weird because I fricking love doing it. Investing in the stock market is so much fun, because it speeds up the whole ride from broke to financially independent.
In one of my earliest posts, I talked about my surprise and delight when I discovered that putting a little money into my work-sponsored 401k every month added up damn quickly. Not least because the stock market is basically the one place left on earth where you can actually make interest on your dollars. I have a $10,000 emergency fund in a savings account, and this month I made a whopping 36 cents in interest on it. Meanwhile my investment account with Acorns has $450 dollars in it and I made about $3 in dividends and $4 in market gains this month. Not that $7 is a lifechanging amount, but we’re talking about the ratio of return on the deposit.
But people are really, really fearful of investing, and I get why. Starting can be confusing as hell. Stocks? Bonds? Buy low sell high? How do you know what high or low is? Mutual funds? Index funds? Actively managed? Capital gains? I know when I started this stuff made my eyes roll back into my head.
But essentially I think the core fear of investing is this: stocks can go down. I might be making tiddly twat on my savings account, but I never have to worry that I’ll log into my bank account one day and see that my balance is lower than the amount I have deposited. And we all lived through 2008. Anyone who saw their friends’ and parents’ retirement accounts crumble under their feet has every right to feel like investing is a sucker’s game.
Long term, however, the stock market is the only place where returns consistently, historically beat inflation. Every year your money loses 1 - 3% of its value. The 36 cents deposited in my emergency fund don’t even begin to make up for the loss of buying power that is sapping the value of my savings every day. The fact is that to build the kind of wealth that will allow you to maintain or improve your standard of living, take risks and even retire some day, you absolutely cannot count on your savings accounts. Savings accounts guarantee loss of value.
“Okay,” I hear you say, “I get it. I hear this all the time. I have to invest, the sooner you start the better compound interest you get, yadda yadda. That doesn’t actually make it easy to start! How do I know if this is the right time to start investing? I don’t want to put all of my money in today and have the market tank tomorrow!”
And to that I say, good buddy, I’d like to introduce you to my friend Dollar Cost Averaging.
Imagine, if you will, that your journey to wealth is a ride up an escalator. You start at the bottom and you need to make it to the top.
Putting your money in an account that earns less interest than it loses to inflation is like trying to walk up the down escalator. You might make it to the top but you’ve chosen a path that’s going to make it as slow as possible.
If you managed to find a savings account that returned 2% or so, exactly enough to make up for inflation, it would be like the money you put into it stepped onto the bottom step of the escalator and then was carried, slowly, to the top.
If you decide to stockpile your cash somewhere and then dump it into the stock market all at once, or you invest heavily in a single company’s stock, you’re taking a giant leap onto the escalator. You’re hoping that you’ve picked stocks that are a bargain when you buy them, and that their value will grow. If you managed that, your leap will start you 6 or 7 steps up the escalator, instead of on the ground floor. Now you can just stand there and ride it to the top looking like the winner of life.
Or you could invest in a bubble and have your stocks lose significant value when the bubble bursts. That’s like leaping onto the escalator, losing your footing, then tumbling to the bottom, and lying in a broken heap on the first floor, needing time to recover before you can even try stepping onto the escalator again.
A lot of people try leaping. A lot. Every story you’ve ever heard of people making a killing on the market or people who lost it all, they all leaped. This is literally the definition of many Wall Street jobs, is to be good at leaping.
And people get addicted to it. If the successful leaper made a killing on a stock, sold all their shares and then plopped it in savings to earn 1% interest, they’d probably do pretty well. But no! If they made the leap once, they can surely make it again! So they try to leap from step 7 to step 15, from there to step 20. Each time, the chance of slipping is the same. Maybe a few lucky jerks make it to the top without a hitch, but way more people are going to slip on at least one or two of those leaps. They’re all over the place. They go up, they go down, they fall, they jump again, constantly trying to find the “secret” way to leap that will make them the special person who never falls. It’s a roller coaster ride.
I don’t know about you, but the prospect of tumbling off the escalator is just way way too scary for me. Time and again we’ve been shown that individual companies can appear to be healthy and growing, right up until the CEO declares bankruptcy or goes to jail for misuse of funds.
So what I do instead is I dollar cost average. This means that I buy a little bit of stock every month at the same time. Whether the market is high or the market is low, I make my deposit. I don’t try to time it, I don’t try to beat the game by leaping onto a top step. Every month, a small deposit. Literally, I’m trying to match the market, peak for peak, valley for valley. I know that historically the entire market will gain 7 - 8 percent over my lifetime, and that’s plenty for me. So I just want to ride the wave and trust in time and compound interest.
Also, I don’t invest in single companies. I only invest in index funds, meaning you give your money to someone who spreads it out over many many companies. I own tiny percentages of many different stocks. This means that one company tanking isn’t going to knock me off the steps. My risk is spread out.
Picking an index fund to buy into is actually easy. The only quality you really need to measure is the fees they charge for spreading your money out for you. Even a great leap-er can get screwed by fees. Investing in funds that charge high fees for managing your accounts is like having to take a step down every few minutes. The escalator keeps going up, but not all of your money is riding it. So only invest in funds that have a fee ratio of <1%
Dollar cost averaging, riding the market every step of the way, is like walking up the escalator. Maybe sometimes the escalator slows down, maybe it even runs backwards occasionally, but I keep moving my legs, and I trust that the escalator is carrying me up more than it’s carrying me down. History tells me that I will get there faster than the person standing on the step letting the escalator carry them, and that I will get there more surely than the person who risks it all on leaps.
It’s working great so far. I hope you’ll join me, and we can all have a party on the top floor.