If you’re going to start investing, one of the most recommended techniques is dollar cost averaging. New investors will likely have a blank expression when they come across this term and wonder what is dollar cost averaging? To simply put it, it’s a tactic where you’re making regular investment purchases regardless of the price.
This is ideal for investors who only have a set amount that they can invest every month. When prices are higher, you buy fewer shares, but you buy more when prices are down. As long as you keep investing, you’ll be fine. There’s no point in trying to time the markets. Let’s take a closer look at what is dollar cost averaging.
How dollar cost averaging works
Dollar cost averaging works as long as you’re making monthly contributions. Let’s say you’re investing $100 at the start of every month. As long as you ignore the current price and invest your allocated amount, everything will average out. Here’s what a year of investing would look like using hypothetical prices.
|Month||Amount invested||Unit price||Units purchased|
As you can see, you’re investing the same amount every month, but you get more or fewer units depending on the price at the time of purchase. In this scenario, you would have invested $1,200 in total, and you have 120.14 units. On average, each unit would have cost you $9.64.
Why should you dollar cost average?
The purpose of dollar cost averaging is to eliminate any emotional investing and market timing. For example, many investors may not want to put their money in the market because they’re worried that certain conditions may drive prices down in the future. While no one wants to buy at the top, it’s impossible to tell when markets will fall.
One common piece of advice regarding investing is that it’s time in the market, not timing the market. As long as you keep investing instead of putting your money on the sidelines, compound interest will take care of itself.
Dollar cost averaging is incredibly easy to do these days if you’re set up with a robo advisor such as Wealthsimple, Justwealth, or Tangerine investmentnt funds. Just set up an automatic monthly contribution, and the robo advisor will do the buying for you.
If you use a discount brokerage, you can also set up automatic purchases, but you would likely need to call in to set it up first. You would also need to ensure you have the funds available in your account before the trades go through. Note that dollar cost averaging isn’t the best idea if you need to pay a brokerage fee with each transaction.
Should you make a lump sum investment instead?
Research from Vanguard found that 64% of investors that make a lump sum typically see higher gains than those who dollar cost average. If that’s the case, why does dollar cost averaging still get recommended so much?
The main reason is that most people don’t have a huge amount just sitting around ready to invest. If you happen to have a couple of thousand dollars sitting in your account right now, go ahead and invest everything at once since you can take advantage of the time in the markets. However, most people only have a few hundred dollars available each month to invest, which is why it’s better to dollar cost average.
Remember, dollar cost averaging is also psychological. Let’s say you inherit $100,000 but you’re worried about market conditions. Instead of throwing everything in at once and freaking out if there’s a drop, you could invest $10,000 a month for 10 months or $25,000 quarterly. You’re accepting that you’ll buy at average prices, so there’s no emotional attachment.
How dollar cost averaging works in real life
The above are all basic theories, but some people still really understand how dollar cost averaging works so let me explain my journey with it.
After I got my first job at 18, I started investing $25 a month into my Registered Retirement Savings Plan. I was purchasing mutual funds, so there were no brokerage fees to worry about. After about five years, I switched to an investment advisor, where I increased my monthly contribution to a few hundred dollars a month.
After firing my advisor, I went the DIY route and started investing in TD e-series funds. Setting up automatic purchases was easy in the e-series mutual fund account, but as I became a more experienced investor, I decided to open an account with TD Direct Investing. By this time, I had a defined benefit pension with my employer and little RRSP room, so dollar cost averaging didn’t make sense anymore. Instead, I made a lump sum payment once a year.
There were no robo advisors when I started investing, which is why I cycled through multiple financial institutions. These days, I recommend robo advisors from the start since they have low management fees.
Dollar cost averaging is the perfect strategy for new and experienced investors. Not only will you be making regular contributions, but you’ll also avoid any emotional investing. The key thing is to stick to your plan and work towards your long term goals.