Dollar Cost Averaging

Market volatility is a common and natural part of the financial and investing landscape. Every day investors face new headlines, economic data, and other developments that can positively or negatively impact their investment portfolios. Since no one can predict market movements with absolute certainty, the world of investing can sometimes feel overwhelming or intimidating, especially for newer investors.

As Canadians beginning their investing journey, some may want to explore a more simple and straightforward approach to investing while being able to manage uncertainties and volatility in the financial markets. A common investing approach used by both novice and experienced investors is “dollar cost averaging (DCA)”.

Gaining a clear understanding of how DCA works can empower you as an investor to handle volatility with more confidence, build consistent investing habits, become more disciplined, and make informed financial and investing decisions.

What is Dollar Cost Averaging (DCA)?

DCA is where you invest your money into an investing product (e.g. ETFs, mutual funds, stocks) at regular intervals. This is different than the lump sum approach where an investor would invest their money all at once. For DCA, the intervals for your investment purchases could be daily, weekly, monthly, or any other timeframe that is suitable for you.

DCA may help reduce fear, uncertainty, or other emotions when investing. Rather than trying to “time the market” and buy at the lowest price possible, DCA focuses on consistency in order to help you potentially gain long-term investment growth and returns. Regardless of how the overall market or investment may be performing, DCA allows you to continue investing at regular intervals and may help reduce and ease some of the emotions involved with investing. DCA can also be helpful in managing your overall risk and enables you to spread your money over a longer time horizon.

How Does Dollar Cost Averaging Work?

Let’s look at a scenario where you want to invest your first $1,000 in an ETF index fund. Instead of purchasing it all at once (commonly referred to as lump sum investing), you instead spread your purchases over the course of one month and buy on a weekly basis.

This is an illustrative example of an investor who uses DCA to purchase an index fund ETF. In this scenario, your $1,000 would be split into weekly purchases. After one month, your average share cost using DCA would be $98.00. This would be different than an investor that decided to invest $1,000 with a lump sum in week one where the price was at $99.00.

If you have a pension plan or a retirement account through your job, you might already be using dollar cost averaging without realizing it. That’s because you and your employer put money into your retirement and/or pension account on a regular schedule. These contributions generally happen every time you get paid. The DCA approach can be used for your investments in both a registered account (e.g. TFSA, RRSP, FHSA) or a non-registered account.

It is important to know that DCA does not prevent investment losses or guarantee your investment returns. Your investments can still lose value depending on market conditions. Simply put, DCA just changes when and how your money is invested.

Dollar Cost Averaging Funds (DCAF) and How They Work

Alternatively, there are dollar cost averaging funds (DCAFs). Imagine a DCAF as a waiting room for investors wanting to invest a lump sum but are more risk averse.

An investor has $10,400 that he wants to invest in the market. This total amount is used to purchase short-term fixed income securities that earn interest. Instead of investing the total amount into the markets at once, the DCAF takes 1/52^nd of the total lump sum and automatically invests it into a specific fund of your choice every week for a year. In this example where the investor starts with $10,400, $200 is transferred every week from the DCAF into the desired equity fund. This process continues until the total balance is moved. Spreading your purchases over various price points throughout the 52 weeks helps lower your risk while still gaining exposure to the markets.

Like other investment funds, DCAFs also have fees and costs. The total fees charged by DCAFs may either be higher or lower than the subsequent fund the money gets invested in. It is important to speak to your registered advisor and/or firm to better understand these fees and costs, as they can significantly impact your overall investment returns.

The Benefits of Dollar Cost Averaging

1. Avoid The Urge to Time the Market: Even the most experienced investors cannot consistently time the markets and predict the best time to buy. DCA helps an investor spread their investment purchases over time and eliminates the urge to try and buy a stock or ETF at the bottom.
2. Reduces Emotional Investing: Volatility in the markets is common. This volatility may lead you to make emotional investment decisions and may lead to “panic selling” or “FOMO” (fear of missing out). DCA helps instill discipline and consistency and helps keep you on track in achieving your investment goals and avoid reacting to market downturns or headlines.
3. Accessibility and Ease: Some investors may not have a large lump sum ready to invest right away. DCA encourages investors, especially newer investors, to start small and slowly and steadily grow their investment portfolio over a longer time horizon.
4. Recurring Investments and PADs: Some investment dealers and firms allow pre-authorized deposits (PADs) and recurring investments. With a PAD, you can authorize a fixed amount of money to be deposited from your bank account into your investment account. With recurring investments, you may have the option to automate the purchase of an eligible investment product at a set interval (e.g. weekly, monthly, etc.). These options make the process of DCA much easier.

The Drawbacks of Dollar Cost Averaging

1. Fees and Costs: Frequent transactions may lead to higher commissions and other fees, depending on your investment platform or firm. This can eat away at your investment returns over time. The good news is that some investment dealers now offer low or zero commission fees when buying and/or selling. It is important to check your investment dealer’s fee structure.
2. Lower Potential Returns in Rising Markets: If an investment continues to increase steadily in value (such as in a bull market), then using DCA would result in lower potential returns versus investing your money with a lump sum.
3. Lack of Compounding: By using a DCA approach for your contributions instead of a lump sum, you lose out on the ability to compound your investments as you are delaying the full amount invested. If you have the available funds to make a lump sum contribution at the beginning of the year you may potentially experience higher investment returns when compared to DCA because of the power of compounding which could help your investments grow right from the start.

Conclusion

DCA is a common practice that allows investors to invest gradually over time using a regular and fixed contribution schedule. DCA may help investors manage uncertainty and develop consistent and smart investing habits over a long period of time. However, it’s important that you review and consider your risk tolerance, overall investment goals, and understand how DCA may align with your long-term and overall financial goals.