Dollar-Cost Averaging: Easy, Smart, but is it Better?

Most people are not sure whether they should invest their hard-earned dollars into the stock market all at once, or slowly, over a relatively short time frame. When you put all your money in at the start, it is known as lump-sum investing. Investing slowly over a period of time is  known as dollar-cost averaging.  

Now imagine that you get a raise or earn a promotion. You have an extra $5,000 that can be invested. 

What should you do? 

Read through the article and find out. 

Dollar-Cost Averaging Definition

Dollar-cost averaging (DCA) is investing a pre-determined amount of money on the same day/week/month/quarter/year no matter whether the stock market is surging or declining. Come rain or shine, you invest. No ifs ands or buts. 

This is a risk management strategy that changes how you invest, but it does not change your investments. You can choose the same equities or fixed-income securities whether you DCA or lump-sum invest. 

The main benefit of a dollar-cost average strategy is that you buy more units of an ETF/stock/bond when the price is low, and less units when the price is high. Therefore you will get an average cost over time. You buy systematically whether the stock market is up, down or sideways. 

Everyone has heard of the term “buy low and sell high”, but investing is more complex than that. We have certain investor behaviours to overcome (such as fear and greed) and general market “noise” (TV programs, news articles, social media threads) to avoid with respect to the  stock market. These factors present major challenges for most investors.  

You can also benefit from a dollar-cost averaging strategy as it will help reduce the amount of emotional investment decisions you make.

Dollar-cost averaging is a psychologically comforting and risk averse way to keep investing simple because over long periods of time equity values in North America rise.

But….

In the short-term that is not always the case, and market drops can be sudden and quick. 

Many investors fear investing at the “top” of the market.  A lot of times it can feel like the stock market is ready to drop because the S&P 500 has been setting records month after month for years since the Great Financial Crisis in 2008/2009. It is natural for you to think, “how long can this upward trend last?”

You may hold large amounts of cash hoping for a market crash, but since the markets tend to rise most of the time, you eventually get left behind.  Waiting for the stock market to correct or enter a bear market before investing heavily is a form of market-timing which is proven to be an inferior investing method.

Benefits of Dollar-Cost Averaging

  1. You create a consistent investing habit. You likely get paid every two weeks or monthly. That makes it the perfect time for you to invest using a DCA strategy. Buying and holding index ETFs that track the S&P 500 or S&P TSX 60 can help you build wealth over several decades. 

    By purchasing your assets every few weeks you become accustomed to buying no matter what the price is. Doing the same thing over and over, builds a habit.
  2. You purchase more and lower your costs when the market drops. When the stock markets falls 20% or more from it’s all-time high, it is a known as a Bear Market. This is the best time to buy equities as they are on sale. 

    The beauty is that, without changing your plan, your regular dollar-cost averaging approach will help you buy more units of your favourite equities or fixed-income assets for each dollar invested.

    The best part? This approach will help you realize that bear markets are not to be feared, but cheered when you’re in your asset accumulation stage.
  3. It is a stress-free and automatic way to invest. Purchasing investments regularly go hand-in-hand with setting up automatic investments straight from your paycheque.

    This is known as “paying yourself first”. Each payday you can instruct your bank to take out $100 and invest it into a mutual fund or move it to your RRSP or TFSA and invest in whichever ETFs or individual stocks, fixed-income assets you want.

    There is no guessing with this strategy, and you don’t have to worry if oil is spiking, inflation is rising, interest rates are dropping or there are trade wars. You just keep buying consistently. 

    Humans adapt fairly easily to changes, and if you need to live on $200 less per month because you’re investing, you will find a way.
  4. You lose interest in market-timing. Remember that some investors feel like the stock markets are always poised for a drop and they hold too much cash on the side waiting for a big correction or crash. 

    Greed and fear run the stock market, and these are two extremely strong human emotions. 
    With DCA, you can ignore all the fearful or greed-inducing news about the macro economy because you’re buying no matter whether the market is up or down.

    Since our emotions often hinder our investment performance this simplified strategy can yield stunning results. A side benefit is that  you are far more likely to stay invested all the time.
  5. It is a form of risk management. The fear is always that if you invest a large sum of money the market could drop by a lot in the next few days or months. However dollar-cost averaging reduces the volatility of your portfolio because you are “averaging” yourself in slowly over time.

    So if the market drops you’re buying some of your assets at lower prices than before. And, if you have poor timing you don’t get hurt as much as if you had made a lump sum investment. If the market keeps going up then you will still feel good because you’re still “in the green” (making a profit).
  6. It helps you invest as early as possible. Dollar-cost averaging is great for beginner investors who also don’t have a lot of money to put into the stock market. This is especially true when you are just entering the workforce.   

Drawbacks of Dollar-Cost Averaging

Of course, there are drawbacks to dollar-cost averaging too. Here are the main imperfections.

  1. Lower Overall Return. Because dollar-cost averaging means you have some money in cash (or GICs) on the side it means you will likely lag the returns of a lump sum investment because the stock market spends more time going up than down.
     
  2. Higher cost of average during bull markets. The prices mostly increase during a bull market (which last longer on average than bear markets), so your average cost in subsequent months will generally be higher than the month you first started investing in.

    If you bought a well-diversified ETF at $50 in month 1, by month 2 it could be $51, then $51.50 in month 3 etc. If you had enough money to make a lump sum purchase in month 1, you would have an average cost of $50.  
  1. Commission fees can nullify the benefits.  Although many online brokers are removing costs associated with purchasing ETFs or stocks, there are still some brokerages that apply a $5 or $10 fee per trade. 

    If you are dollar cost averaging smaller amounts (less than $1,000 per trade) then the fees may outweigh the future benefits you can get from a DCA strategy. You might be better off making a lump sum purchase. Higher trading fees eat into your potential returns. 

Dollar-Cost Averaging Example

Enough of the talk, right? Let’s see some numbers in action.

The example below shows the difference between making a lump-sum investment (LSI) of $5,000 into an ETF immediately versus dollar-cost averaging (DCA) $500 per month over 10 months into the same ETF.

With a lump sum investment of $5,000 at a share price of $50 you purchase 100 shares. 

With a DCA strategy you regularly contribute $500 each month for 10 months to purchase $5,000 of the same ETF. Keep in mind that the price of the ETF doesn’t stay the same over the 10 months, it is always fluctuating. 

Example 1: Investing During a Downturn

As you can see below the price starts at $50 per share, drops to a low of $35 per share and ends up at an all-time high by month 10 at $58 per share. Using the DCA strategy, you end up accumulating 108.24 shares over the 10 months. 

The final portfolio balances are $5,800 ($58 x 100 shares) for the LSI strategy and $6,277.92 ($58 x 108.24 shares) for the DCA strategy. The DCA strategy won out in this case, because the markets spent more time under the original month 1 ETF price, than it did over it. In other words, the DCA strategy can be more profitable if there is a stock market crash or correction.

Lump-Sum Investment (LSI) of $5,000 vs Dollar-Cost Average (DCA) of $500 per Month

MonthShare Price LSI ($)Shares Purchased LSIShare Price DCA ($)Shares Purchased DCA
1501005010.00
2  4511.11
3  4012.50
4  3514.29
5  4211.90
6  4511.11
7  5010.00
8  529.62
9  559.09
10  588.62
Totals 100 108.24

In this example, by month 4 the stock market had dropped by 30%. If you had made a lump sum investment, your $5,000 would have dropped to $3,500. 

Remember your average cost per share would be $50 and your investment would only be worth $35 per share. Would that scare you? Would you feel like you could withstand the anxiety and pressure of seeing your portfolio doing so poorly, so quickly? 

On the other hand by month 4 at the bottom of the market (which again – people can only look back in history and know that it’s the bottom) your average DCA strategy cost would be $41.76 ($2,000 invested divided by 47.90 shares purchased). Since you are buying more shares all the way down at the market bottom you are only 16% down in your portfolio overall as opposed to 30% down in the lump sum scenario.

That is proof that your portfolio would have less volatility if you use a dollar-cost averaging strategy rather than a lump sum strategy.

Emotionally this could be a big factor for you. Investing this way could keep you invested the whole time, whereas with a lump-sum investment you might sell all your shares and only return back again in month 8.  You know yourself best, but do realize that actually experiencing a market drop is quite different from taking a risk tolerance survey.

Example 2: Investing During an “Up” Market

Most of the time the stock market is in an upward ascent. So the following situation may be more realistic. Once again if you are using a lump sum investment strategy you purchase an ETF for $50 per share and receive 100 shares, with a total cost of $5,000.  

With dollar-cost averaging you end up buying fewer units throughout the year as the stock market spends a lot more time in an upward trend. Here, you end up with 94.07 shares. 

At the end of the year, the lump sum strategy leaves you with a balance of $5,800. The dollar-cost average scenario leaves you with a final balance of $5,456. In this case you’re better off investing once with a large lump sum amount. 

MonthShare Price LSI ($)Shares Purchased LSIShare Price DCA ($)Shares Purchased DCA
1501005010.00
2  529.62
3  539.43
4  559.09
5  519.80
6  4910.20
7  539.43
8  559.09
9  578.77
10  588.62
Totals 100 94.07

Again, because the stock market increases more than it declines over the long-term, you are likely to be better off with a lump-sum investment. 

Who Should Consider a Dollar-Cost Averaging?

You might want to consider dollar-cost averaging if you:

  • Are a new investor who has a smaller contribution amount. You can build up your investment portfolio slowly and get into the habit of investing while decreasing your risk exposure.
  • Want to enjoy life and make investments stress-free. There is a lot of noise that comes with following the stock market closely and a lot of it doesn’t matter especially if you are choosing from a bunch of great index based ETFs you can find in Canada. You don’t have to waste a lot of time researching, you just stick to an easy plan. 
  • Are making regular contributions to your child’s RESP, your TFSA or your own defined benefit contribution plan. 
  • Know you have a low risk tolerance and you are known to panic when your portfolio drops due to market crashes.  

You might consider investing in an alternate way if:

  • You are a day or swing trader. With day trading you are looking to invest a lump sum and exit the position within the same day. It would not make sense to dollar-cost average hour by hour.  
  • You have a high risk tolerance. It wouldn’t bother you if you invested $50,000 in one go and the market crashes by 30%. If you can withstand that drop in portfolio value without selling, then you may be better off investing all at once. 
  • Your brokerage fees are high. If you have to pay $10 per trade then it may not make sense to make weekly or monthly contributions especially if your contribution amounts are on the lower end. If you have $500 to invest every month then paying $10 per trade equals a 2% trading fee cost. If you have $200 to invest, you are losing 10% to fees alone. 

    However there are brokerages like Wealthsimple ($0 trades for Canadian ETFs, stocks and bonds), Questrade ($0 purchases for ETFs) or National Bank ($0 trades) that allow you to invest for no cost at all, depending on what you’re purchasing.  

Is Dollar-Cost Averaging Good for You?

A Vanguard research study shows that most of the time you are better off investing a lump sum rather than waiting and dollar cost averaging over a period of time. 

It is a trade off between potentially maximizing your returns versus lowering the risk of falling investments soon after purchasing.

From a psychological standpoint it may be best for you to DCA if you cannot stand to see your portfolio go down straight away.  You may get lower overall returns, but the name of the game is to stay invested.  

Dollar cost averaging helps you stay invested through down markets, because you are buying all the way down so you’re getting cheaper prices. 

I am going to repeat this again, to hammer the point home. Remember investing is not only what you buy, but it also about your mental makeup and your investor psychology. DCA prevents you from over-buying when the markets are high and everyone on Bay Street and Wall Street is feeling rosy, and from selling during the depths of a market crash.  

Investment Food For Thought : Considering Your Asset Allocation

What if you are risk averse but you want to lump-sum invest? 

Well, you could choose to switch your asset allocation to reduce risk.

For instance instead of holding a $100,000 portfolio that is 100% invested in equities, you could opt to hold it as $70,000 in equities and $30,000 in fixed-income and cash. That way an immediate market downturn might not leave you in a state of panic and ready to sell out.

At the end of the day, dollar cost averaging is a tradeoff between your risk tolerance, lifetime return potential and your investor psychology. 

The research shows that investing a lump sum wins two-thirds of the time.  But only you know your emotional investing state of mind. If you get antsy and cannot handle losses, then investing when the stock market seems high is hard to do. 

If you have a long-term mindset then you may feel comfortable investing all at once. Even still, short-term losses may be too much for you to bear.

This is worth noting as well, you can lose money no matter which strategy you use, whether it is dollar-cost averaging or lump sum investing.  

CONCLUSION 

If you’re a long-term investor it should matter very little whether you dollar cost average or lump sum invest. The longer you are invested in index ETFs that track reputable markets like the S&P 500 and TSX 60 the more likely you are to see a positive return. If the market crashes the day after you invest a lump sum, you have many years to wait for it to recover.     

Dollar cost averaging is a strategy designed for the long-term, although it can provide the benefit of risk management for short-term investments as well. 

No one knows how the stock market will move at any given time. Everyone is guessing. What seems like a high price today could end up being an unbelievably low price half a decade from now. Or it could be the all-time high eight years from now. 

No one knows which direction the stock market is going to go in the short to medium term until they can look back in hindsight. This is why market timing doesn’t win in the long-run, and why dollar-cost averaging is a solid strategy for you to consider.

Dollar-Cost Averaging FAQs

What are some benefits of dollar-cost averaging?

Some of the biggest benefits of dollar-cost averaging are that you can automate the process to make it easy to invest, you can start investing with low dollar amounts, it take the emotions out of investing, you can manage risk and you can buy more as the stock market drops.

Is dollar-cost averaging a good idea?

Dollar-cost averaging can be a good idea if you have a lower risk tolerance, because you ease yourself into making purchases when the stock market is high. If you have a large pile of cash to invest, two-thirds of the time you’re better off investing it all at once, because it produces higher returns since the stock market is generally in a bull market.

Can dollar-cost averaging make you rich?

If you are increasing your savings rate and using that excess money to invest consistently, then dollar-cost averaging can help you build wealth over a few decades. It takes the emotion out of investing and helps you build a strong habit of investing.

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