What is Dollar Cost Averaging?
Dollar Cost Averaging (DCA) is an investing strategy that involves buying investments at regular intervals, usually for a fixed amount, and often with smaller amounts of money. This is opposed to waiting until you have accumulated a large, lump sum, and then investing it all at once.
Dollar cost averaging has become enormously popular as a method of investing, and provides several key advantages for investors at all levels. Still, there are those that downplay the benefits of dollar cost averaging, in favour of lump sum investing.
In this article, I’ll explain why dollar cost averaging works, and how you can use it to reach your long term financial goals.
Two Ways to Use Dollar Cost Averaging
There are a couple of ways you can dollar cost average your investment contributions. The first is to break up a lump sum and then place it into the markets over an extended period of time.
For example, let’s say you have $50,000 to invest. You could place the full amount into the market in one lump sum, or you could choose to break it into 5 groups of $10,000, and invest $10,000 each month for five months, or spread it over a longer period. There are a number of reasons an investor might choose to do this. For starters, they avoid the temptation of trying to time the market, which is never a good strategy. If you felt as though the markets may be headed for a downturn, you can lessen your risk, as well as your anxiety, by investing small amounts over a longer period of time.
Even if you don’t have a lot of money to invest, you can still benefit from dollar cost averaging. In fact, this is how most Canadians contribute to their RRSPs and TFSA accounts. They start with increments of as little as $25, automatically debited from their chequing account on a biweekly or monthly basis. By purchasing units of an ETF, or mutual fund, at regular intervals, the idea is that over the long term, you will purchase shares at a lower average price, resulting in reduced volatility and higher returns.
Dollar Cost Averaging vs. Lump Sum Investing
It’s probably no surprise that there exists some dispute as to whether dollar cost averaging is a superior strategy to lump-sum investing. In fact, some studies suggest the opposite, that investing with a lump sum results in higher returns more than 50% of the time.
The idea being that if you have a lump sum to invest, the earlier you can get all of it invested, the better, regardless of the current market outlook. More time in the markets means better returns over the long run. Regardless, the benefits of dollar cost averaging are indisputable, and a big part of that has to do with emotions.
Benefits of Dollar Cost Averaging
Dollar cost averaging removes your emotion from the investment decision. Regardless of your risk tolerance, anytime you invest money into the stock market, emotions are going to play a factor. For example, it’s easy to be fearful when markets are dropping, and it’s just as easy to be greedy when the markets are soaring. After all, everyone wants to ride the wave. Unfortunately, emotional investing almost always leads to poor decision making, by trying to time the market.
Dollar cost averaging automates the investing process. These days, all financial institutions make it easy to DCA, by enabling pre-authorized payments from your chequing or savings account, directly into your investment account. From there, fund units can be purchased automatically, in almost any amount. Automating your contributions takes the work out of investing, and increases the likelihood that you’ll stick to your long term goals.
DCA allows you to invest early and often. Not everyone has a large amount to invest. Dollar cost averaging allows young investors, or those on a limited budget, to begin investing regardless of their cash flow situation. After all, the earlier you start investing, the better, even if it means doing so $25 at a time. With DCA, you don’t need to wait until you have $50,000, or even $5,000, to get started.
Important Tips for Dollar Cost Averaging
So you’ve set up your pre-authorized payment, and you’re ready to reap the rewards of dollar cost averaging. Not so fast! Here are four things you’ll want to keep in mind as you begin investing.
Don’t Forget to Rebalance
Because different investments rise and fall at different times, it’s important that you review your investments on a regular basis, and rebalance when needed, to stay within your recommended asset allocation. Maintaining the proper asset allocation will have a greater impact on your returns over the long term, than picking the right investment fund.
Start Investing Early
The earlier you start dollar cost averaging, the greater your potential returns will be. Don’t worry if you can only contribute a few dollars per month. You can always increase your contribution amount as your income grows. By dollar cost averaging, you’re building a savings discipline early, and that’s important.
Don’t Focus on the Short Term
While it’s important to review your investments on a regular basis, it’s not a good idea to do it too often. For example, if you’re watching your investment’s performance on a daily, weekly, or even monthly basis, you’ll tend to develop a more short term focus, which could result in something called myopic loss aversion. When you begin to look at everything with a short term lens, it could result in you reacting negatively to losses during a period of market turbulence, as you lose sight of your long term goals.
We saw this happen on a major scale as recently as 2008 when the market crashed. Millions of investors exited the market when their funds began to drop sharply. They lost focus of their long term goals and weren’t able to benefit from the strong rebound in the subsequent years.
Understand Your Investment Costs
Nothing will take a bigger bite out of your investment returns than having to pay high investment fees. When you dollar cost average, your making investment purchases on a frequent basis. It’s important to understand what it’s costing you, in the form of trading commissions, management fees (MERs), or account fees ie. monthly or annual. Thankfully, in 2019, you don’t have to pay for expensive investment advisors or high trading fees. Let’s take a look at some ways to dollar cost average while keeping your costs down.
DCA Investment Options
You may be wondering how to get started with dollar cost averaging. If you have an investment account, such as an RRSP or TFSA, open already, you can ask your financial institution how to go about setting up a pre-authorized payment plan. They’ll want to know which account the funds will be coming from, as well as where you want the funds to go.
I strongly recommend that you check out the many low-cost investment options that are out there. In this day and age, investors no longer have to settle with high priced investment advisors, or expensive actively managed mutual funds. Canadians can now choose from a huge selection of low-fee exchange traded funds, either through a discount brokerage like Questrade, or a robo-advisor service, such as Wealthsimple.
Dollar Cost Averaging With Questrade
In Canada, there is no shortage of discount brokers to choose from, but at the moment, Questrade is our top choice here at MapleMoney. They combine the lowest fees in the industry, with a top-flight trading platform and mobile app. Best of all, with Questrade you can purchase ETFs without paying any commission fees. ETFs are an ideal solution for investors looking to dollar cost average, because you can buy them in small amounts, and they carry incredibly low management fees (MERs), as opposed to mutual funds, which are more expensive.
Unlike many of their competitors, Questrade doesn’t charge an annual fee on any of their accounts. You can open a Questrade account in a few minutes, completely online, and begin the process of setting up your dollar cost averaging strategy (pre-authorized purchase plan). Questrade has an experienced customer service team available who can help with the process.
Dollar Cost Averaging With Wealthsimple
If you value low-fee investing, but prefer a more hands-off approach, you can still get the benefits of dollar cost averaging through a robo-advisor. Wealthsimple is widely considered Canada’s top robo-advisor, and one I highly recommend. They are adding innovative products and services all of the time, and offer state of the art AI technology to investors at all levels.
By dollar cost averaging into Wealthsimple Invest portfolio, you can put your savings on auto-pilot. Your funds will be invested into a low-cost ETF portfolio that’s right for you. By automating your contributions, you’ll come out ahead in the long run. You can open a Wealthsimple account online within minutes, and start investing right away. With Wealthsimple, you can contribute to a variety of account types, including non-registered, TFSA, and RRSP.
In fact, if you sign up through MapleMoney, your first $10,000 will be managed free of charge for the first year. Normally, portfolios up to $99,999 carry a fee of .50% per year, .40% for portfolios $100,000 and over.
Does Dollar Cost Averaging Work?
As I mentioned earlier, there are always going to be conflicting opinions when it comes to dollar cost averaging. Many experts will tell you that lump sum investing is favourable, as it gets more of your money invested sooner. But that approach doesn’t benefit a young investor who may only have a few dollars left over to invest, once the bills are paid. The message could serve to discourage, in fact.
Other gurus will go on about the superior returns they can get from value-based stock picking and claim that there is no real strategy to dollar cost averaging into the same fund, regardless of price. The problem here is that 99% of us aren’t hedge fund managers. We don’t have the expertise, nor the time, to consider ultra-complex, high risk investment strategies. It’s also difficult to achieve proper diversification by investing in individual stocks, without having large sums of money.
Dollar cost averaging discourages emotional investing decisions, it promotes consistency and discipline, and it enables just about anyone to take control of their financial future. For the vast majority of investors, the benefits are simply too compelling to ignore.