Image of a money ladder

Dollar cost averaging: what is it and should you do it?

Dollar cost averaging is contributing money to an investment over time, rather than plunking in a big chunk at one time. You might designate a specific amount to be invested each month (or week, or quarter). Conversely, you might put in your whole amount at the beginning or end of year, or whenever you get that bonus or pension payout or inheritance. Which is better?

I was recently reading an investment article by a well-known academic. He used his model 12 asset portfolio and explored the option of investing $100 every month in that portfolio, for 25 years. The ending account value was $68,580 (your investment was $30,000 total). That didn’t look so hot to me, so I used an online investing calculator which gave an annualized return of 6.062%. He’s weighting each of the assets equally and rebalancing once a month (!!!)   That gives him approximately a 65/35% balance in favor of equities. He is using 12 indexes, which as we all know are not directly investable—mutual funds will likely have a slightly lower performance because of management fees. And, without at least knowing the Standard Deviation, it’s hard to see how much risk an investor would be taking. ~6% is pretty standard a performance.

But there is one advantage of investing monthly—potentially it allows you to buy at a lower average cost per share. If you buy on any given day, you have only one chance in 252 market trading days of hitting either the highest or lowest day. If you invest monthly, you have 12 chances, but it’s still unlikely that you’ll hit the lowest or highest trading day, unless you are very, very unlucky—you’ve diversified your risk. Still, since the market is up more than it’s down, your share cost will increase over time (which is what you’re hoping for, in a way, if you want to make any money). Also, if you’re investing a specific amount of money, you’ll buy more shares when the investment is cheaper, and less when it’s expensive. Finally, setting up monthly investments has the advantage that you might actually DO it. Dithering usually results in skipping at times—and there is never a good time.

But what about if you get a lump sum? By reserving some portion, you’re losing all the dividends and capital gains payments made, if reinvested. Let’s say that instead of investing $100/month over 25 years, you had invested that $30,000 all at once in his asset portfolio, held it for 25 years, and earned 6.062% annually. If I’m pressing the buttons on my calculator correctly, you’d have $130,652.15, over 45% more—so dollar cost averaging a lump sum over time could cost you a lot. But managing $100 a month contribution into 12 assets over 25 years is a pretty daunting prospect—if you can even find funds that would allow you to contribute $8.33 a month to each fund. So, let’s look at something easier. What if you had put that $30,000 “inheritance” into just one balanced fund, say Vanguard Wellington (no investment recommendation intended).  $30,000 invested on December 31, 1997 would have grown to $184,743.75 by December 31st, 2022, according to Morningstar. (I’m using the article’s measurement dates—Dec. 31, 2022 wasn’t a trading day.) I wish I could show you dollar cost averaging into VWELX, but it’s beyond my powers to calculate and the data obtainable—they only show 15 years, where the annualized return is 7.45%.

Those who are more skilled at statistics than I am may find these figures arguable (isn’t almost everything, depending on how you set it up?), so I refer you to this article. Investing regularly has the advantage that you might actually do it. But, while investing a large lump sum may require a big gulp and a leap of faith in the future (and some scary days of bad markets), you’re probably going to be better off than holding back anything in cash.

 

Very surprised dog

Get off the ledge: financial planning in a crisis

It just won’t do any good—no matter what action you can think of, it’s already too late. You couldn’t see it coming, nor could you act fast enough to stop anything. As Dorothy Parker said, you may as well live.

In my more-than-a-decade of telling people they need an emergency fund, never did I think everyone would need an emergency fund at the same time. But such are the times we are living in. And if you have that emergency fund, you now have the freedom to pat yourself on the back and do absolutely nothing.  The working person’s emergency fund should carry you through an interruption in pay checks, even for a significant amount of time. Since you’re going to be at home, you probably won’t be putting a lot of discretionary money into restaurants, air travel, etc. No, this isn’t the happiest news, but adaptability is one of the secrets to a satisfied life.

The retired person’s emergency fund should be larger—2 years. Call it the bucket strategy if you wish, but that cash should carry you into a recovery. Maybe the market won’t be back to where it was, but it’s extremely likely that it will be better than it’s been for the last few weeks. Sure, some things that are passed up never come back—especially services. We might schedule them again, but the missed time is probably gone. On the other hand, no one’s shoes, or tv, or car lasts forever. Eventually consumer demand will swing back up.

I’ve been invested for at least 40 years now, and I’ve seen numerous times where pundits thought the world was coming to an end. Other things I’ve heard way more than once:

  • This time it’s different (Only in the specific details, not in the fact of a downturn or reaction to it)
  • I want to sell everything, wait for the market to bottom, then jump back in (How will you know?)
  • It may never come back (Well, then prices will go down since we’re all in the same boat)
  • I need a much more conservative portfolio (too late on that one)

And in about a year or two…

  • Gosh, I wish I would have bought when the market was down
  • I stayed in cash but then everything took off and I missed it

When the market is high, no one wants to take profits because things could go higher. When it’s down, no one wants to buy because things could go lower. So, it’s never a good time.

No matter what you regret, you can never redo the past. All you can do is learn from it, with honest assessment and perhaps revision. Maybe you’d forgotten what it felt like in 2007-2009, when the S&P dropped to 676—it closed at 2,386 today). Maybe you were too young then to have any money. Maybe you’ve found out that in fact you are far more risk averse than you expected, and when things get boring again, you may want to adjust your portfolio. In the event that you are indeed flush with cash, and can take the risk, there are bargains to be had.

The correct portfolio has the correct balance FOR YOU. If you find you are having heart palpitations, either it wasn’t right for you or you need to get off the screens and go for a walk. Your dog is waiting for you.

 

 

Window offering salary loans

Should you pay off your loan or save?

Yes.

Oh, but you wanted to know, which first? It’s a question that virtually every client asks me, but the answer is (as with so many things) it depends. So, I’m going to suggest you work through this checklist.

You should always pay off the minimum required payment on your loan. If you don’t do that, you’re in a world of hurt and that’s a topic for another time. But I’m going to assume that you can scrape up at least a little more than that and you’re wondering where you should put it. BTW, I’m going to be thinking mostly of education loans, but this advice also applies to credit cards and home mortgages.

  • Do you have an emergency fund?

Without an emergency fund, you’ll never get out of debt. We don’t know what the emergency will be, but we know that they come up fairly regularly. See my post here for more discussion. No emergency fund, no extra loan payoff.

While I like to see an emergency fund of 3-6 months necessary expenses (including loan payments!), it can take people just starting out a couple of years to build to that level. A $1,000 emergency fund is barely survival (one vet bill or car accident deductible can easily wipe that out.) Once you have at least $3-$5,000 in your emergency fund, you can begin to consider other possibilities, but I can’t advise going whole hog until the fund equals at least your health insurance deductible + out of pocket max + rent, utilities, and loan payment for however long it might take you to find a new job.

  • Are you contributing enough to your employer’s retirement fund to get the match?

If your employer matches your contribution, that’s a 100% return on your money up to the amount of the match, e.g., if you contribute 1.5% and they match it at 1.5%. If you contribute 3% and they match 1.5%, that’s a 50% return. (We could keep going—you contribute my recommended minimum of 10%, they match at 3%–30% return). No legit credit card or high interest loan is going to charge you 30% interest. Plus, you get an additional return on this investment and maybe a tax deduction, although I recommend you go with a Roth option if you have it.

Before paying extra on any loans, you should contribute anything you can scrape up until you at least get the full match.

  • Are you saving enough for retirement?

This is actually a different question than the one above. You need to be saving 10% of your income toward retirement, and more if you didn’t start until your mid-30s or later. Until you can put away at least 10%, in most cases I recommend you focus on retirement savings rather than early loan payment.

  • What’s the interest rate on the loan compared to your investment return?

As a rule of thumb, I use 5% as a basic cut point. If you’re a dummy and keep all your money in a savings account, you’re earning .5%-2%, so take it and pay off the loan. But let’s say you have a pretty good investment (maybe, quality mutual funds) and you’re earning an annualized rate of 6-8%.

What’s the interest rate on your loans? Credit cards at 22%? Pay them off as soon as you can. I still recommend that you contribute to the retirement plan first, but maybe only for the minimum match until you get rid of the high interest payments.

Student loans at 6-7.75%? As soon as you’re contributing at least 10% to retirement savings, start attacking these loans. They’re as high or higher than you’re going to earn from investments. Even if your employer only matches at 1.5% and you’re contributing 10%, you’re making 15% immediately + investment gain. However, I can wrap my mind around going after these once you’ve secured the minimum match. It’s not a numbers answer, it’s what will make you feel better.

Student loans at 3.25-4%? I wouldn’t rush to pay these off before term. You’d be better off saving more, even if it isn’t in a retirement account—a quality balanced or target date fund should produce better returns. However, if you have managed to accrue an emergency fund of 6 months fixed expenses, a “goals” fund for whatever your goals are (kid’s college, house down payment, etc.) and you just really want to be debt free, then you should do what will make you feel better. These are pretty far down the totem pole, however.

Mortgage? Mortgage interest rates are really low right now, so in most cases there’s no financial reason to pay them off rather than investing any excess money. There are a couple of exceptions: let’s say you have a big bonus or sudden inheritance, and your family might qualify for college financial aid. You might be better off paying off or paying down the mortgage since the value of the house isn’t counted on the FAFSA (it is on the CSS-Profile), whereas an investment account will be counted as available for paying.  The second situation is retirement: most people I talk to feel better when they own their home outright at retirement, since it’s probably the biggest monthly outlay. Just be sure you  have enough for unexpected repairs before you clean out cash to pay off the mortgage. You don’t want to be back borrowing on a line of credit at a higher rate.

As with all things financial, your mileage may vary. There are a lot of moving parts to consider when contemplating loans, and achieving the right balance isn’t the same for everyone. But that’s why people talk to a financial advisor, no?