Even if you have not heard of dollar-cost averaging there is a good chance you have used it in your investment portfolio or through an RRSP at work. It is a powerful investment strategy during the accumulation stage of your financial life.
What is Dollar-cost averaging?
It is the system of investing a fixed dollar amount at regular intervals (monthly, weekly) to purchase investments. Here is a quick example to explain:
You decide to save $500/month and set up an automatic contribution to your investments. Here are the purchases for the first three months.
|Month||Contribution||Cost per unit||Number of units|
After the purchase in March, you have 39.17 units and a total investment of $1,566.80 (39.17 * $40.00). Seeing the unit price decline 20% from January to March, you might assume that you lost money. In fact, you are up almost $67 or 4.45%. This is because dollar-cost averaging automatically makes you purchase more units when an investment is “on sale” and buy less when it is expensive. This is the beauty of dollar-cost averaging, it uses the volatility of investments to your advantage.
A big benefit of dollar-cost averaging is the simplicity to implement, all you need is to determine the amount you can regularly contribute and then you leave it on autopilot. It also helps form the habit of regularly and automatically contributing to your investments.
Dollar-cost averaging helps to control the emotional response when volatility inevitably strikes your investments. When your investments decline in value you can know that you are taking advantage of this decline by buying more “on sale”. This reduces stress and regret through the volatility inherent in long-term investing.
Most importantly dollar-cost averaging removes the decision on when to invest because it is on aut0pilot. It is no longer necessary to spend time wondering “is now a good time to invest? Or should it wait till next week or next month?”. This automatic approach reduces the stress around the timing of contributions and stops the futile attempts to time the market.
The Other Option
Without the scheduled contributions of dollar-cost averaging you must make the decision on when to invest each contribution. This inherently leads to trying to time the market with your contribution. Using the same investment as above; here is an example of what can happen when not using dollar-cost averaging.
The first month you don’t want to put the money in as you don’t know where the market is going, so you save the $500. In the second month you don’t want to invest in something that just lost 40%, so again you wait. Now you have $1,000 in cash and no investments. In the third month you see the investment increase to $40. Now that it is moving in the right direction you invest. Good thing you didn’t buy at $50, too bad you didn’t buy at $30.
In this example you end up investing the same $1,500 but you only have 37.5 units at the end instead of 39.17 units. You also missed any dividends or interest paid out by the investments in the first two months. The worst part is that each month (or week or day) you must decide if you are going to invest or wait for the market to drop/increase. This is a mentally exhausting way to invest. It is impossible to consistently invest at the “right” time, so there will inevitably be regrets on the timing of your investment.
Dollar-cost averaging is a high-impact contribution strategy that is simple to implement and reduces stress and regret. It is a great fit for long-term investment goals that require regular contributions over an extended period of time (ex. retirement).