For our third entry into HNRE’s family financial tenets, we’re going to talk about the power of Dollar Cost Averaging and Compounding. We introduced the concept behind Compounding in our first entry, Pay Yourself First, but we’re going to double down on it and highlight how Dollar Cost Averaging can help you sleep at night.
— HackNow RetireEarly (@ReFIREment) April 20, 2016
I remember a challenge my teacher gave us when I was just a kid in elementary school. The challenge was to go home and offer to our parents that we would empty the dishwasher every day for double the amount of the previous day, starting at 1 penny. The idea here is that your parents will hear that you are going to help around the house for pennies a day and accept on the spot. Well guess what? My parents are smart, but they didn’t catch on to the compounding facet of this challenge and they accepted with pride at this great idea! $0.01 The expectation is that your parent’s won’t catch on to the compounding aspect of this deal.
I won’t make you do the math, but on the first day you earn $0.01, then $0.02 the second day, then $0.04 the third day and so on. By day 10 your parents are paying out $5.12 and you’ve made $10.23. By day 20, get this, your poor, ignorant parents who just want you to do some damn work around the house, are paying you $5242.88 and you’ve already made $10,485.75!!!
Check out a great explanation of this same elementary school challenge from Bloomberg.
Yes! This is legit! Simply doubling your money, starting with a single penny, starts to snowball in value very quickly. This is the power of compounding.
The only downside here is that our investments don’t double every day. According to the rule of 72, it takes 7-10 years to double your principle given historical average returns.
The rule of 72 states that if you assume an average 7% return on your index tracking ETFs, you can expect your principle to double every 10 years. Conversely, if you assume an average 10% return, you can expect your principle to double every 7 years.
Watch this video (feel free to jump to 3:19) from Jim Cramer (CNBC’s “Mad Money” host) on doubling your money every 7 years –
This is free money people!!!
So now we’ve covered the importance of paying yourself first to feed your investment strategy. We’ve also hit on maybe the most important principle in finance – compounding. Now let’s get into Dollar Cost Averaging.
What is Dollar Cost Averaging?
I know, it sounds like another one of those confusing finance terms that you’ve heard thrown around a bit but never asked Siri about. However, like our other tenets, it’s really pretty simple.
The concept of Dollar Cost Averaging is a lifeline that saves you from fear and greed, the emotional drivers of most investors. If you’re anything like me, you’ve tried to time the market – dumping money in when the market is low and pulling it out when the market is high. However, after you’ve attempted this a few times, what happens? The market finally beats you down and teaches you that you’re not smart enough to time the market. Well, that’s a lesson I learned anyhow.
It’s much easy to invest using the Dollar Cost Averaging method and stop worrying about timing your entry and exit points from the market.
The long and short of it is this, you invest the same dollar amount into your chosen investment on a regular interval. That’s it. This is where you set up your automatic monthly draft from your paycheck or checking account, set it and forget it.
The concept is intended to get you out of the habit, or desire, to time the market. It also keeps you invested which means you don’t miss out on any bull markets. You’re always fully invested (minus your emergency funds which should always be kept in cash).
At this point you might be asking, “but won’t I risk paying a premium as the market is riding high and missing out on the dips?” No, no you won’t. And here is the reason: By investing a set amount each month, you are buying fewer shares of your preferred investment when the price is high and buying more shares when the price dips.
This is how you sleep better at night. Stop worrying about buying and selling at the exact right time and instead rely on automated investments and get a good night’s sleep.
Here are some of our favorite tweets about Dollar Cost Averaging and Compounding over the last year. If you don’t follow us on Twitter (@refirement) we would love for you to join us!
— HackNow RetireEarly (@ReFIREment) April 19, 2016
— HackNow RetireEarly (@ReFIREment) August 12, 2016
— HackNow RetireEarly (@ReFIREment) March 16, 2016
Dollar cost averaging FTW! https://t.co/9gWnfwgLdE
— HackNow RetireEarly (@ReFIREment) August 26, 2015
Saves hours of stress and time too. Dollar cost averaging FTW! https://t.co/rj2AlAK5vi
— HackNow RetireEarly (@ReFIREment) August 24, 2015
Be on the lookout for the last entry in our financial tenet series – Travel Hacking.