What is “Dollar-Cost Averaging”?
“Averaging in” is something that we talk about on a regular basis with our clients when they have a large amount to invest at once, but it really comes into it’s own when the markets are more volatile, as we have seen lately. But what does it mean when we use the term “Dollar cost averaging” (DCA)?
Firstly, we should explain that when you invest in a mutual fund you are actually buying units in the fund and each day the price of the unit changes. The number of units you hold remains the same unless you sell any, buy more or have a dividend reinvested. Dollar cost averaging is something that you are doing when you make a regular payment (PAC) into an investment, this can be done by saving monthly, bi-weekly, etc., or if we invest a lump sum over numerous time periods, which we also call “averaging in”.
The most simple way to explain this is by showing an example, lets say you are investing $100 each month:-
1st Month - $100 payment – price of each unit is $1 – you would purchase 100 units
2nd Month - $100 payment – price of each unit is 90 cents – you would purchase 111.11 units
3rd Month - $100 payment – price of each unit is now $1.10 – you would purchase 90.90 units.
Over the three months you have paid $300 and you hold 302.01 units.
Now let’s assume a few months have passed and the unit price is now worth $1.15, this gives your account a value of $347.30. The “Cost” of those units still remains to be $300 assuming no distributions have been reinvested. Alternatively, say the unit price went down to 95 cents; the value would be only $317.91, but still only “cost” you $300.
In the same market conditions as the above example, if you didn’t pursue the DCA method and invested the full $300 in Month 1 ($1 per unit) and the price per unit increased to $1.15, you will have $345 which is less than the $347.30 if you “averaged in”. If the price per unit decreased to $0.95, you will now only have $285, and lost $15, rather than still being $17.91 in the positive if you averaged-in!
The process of making regular investments reduces the overall volatility of an investment because you buy a different number of units each time, sometimes more, sometimes less and this process averages out the risk as apposed to make a lump sum purchase on one day.
The real benefit of dollar cost averaging is when you have bought units or shares at a lower price, i.e. you’ve bought more units or shares for your $100 and then the price rebounds. It also helps to put peoples minds at rest if they are planning a large lump sum investment and don’t feel comfortable investing it all on one given day.
We use this strategy with our clients all the time but even more so when we are in a period of market uncertainty. If you are interested in setting up regular payments rather than trying to invest lump sums before the RRSP deadline, let your advisor know and we can get you started.