What is Dollar Cost Averaging?
Dollar cost averaging (DCA) is an investing strategy to mitigate market timing risk that you need to know about when managing your portfolio.
The idea behind dollar cost averaging is to space out the purchasing of your principal over a set a time to limit the effects of the changes in the market.
This can be done over any set of time. The usual time periods tend to be close to a month, however there is no ‘best frequency’. In addition to no best frequency, there is no minimum amount of money required to dollar cost average. As long as you have enough to purchase one share, you have enough to dollar cost average.
Usually employed by long term investors, this strategy is used to limit the negative effects of the market on your intended position. By purchasing at continual intervals, you keep lowering your average price per share.
This subsequently limits your losses and increases your potential for returns. Dollar cost averaging can also have the opposite effect. If your selected stock is always up in price when you purchase then your average price will become higher, which lowers your return when compared to dumping your principal at your initial position.
Positive and Negative Examples
When thinking of dollar cost averaging, we can prove both the positive and negative effects of this strategy by analyzing a hypothetical position in Vanguard S&P Small-Cap 600 Growth ETF (VIOG:NYSE) and iShares Core S&P 500 Canadian Hedged Index ETF (XSP:TSX).
By analyzing these two ETFs, it makes it clear to see both the positive and negative effects of dollar cost averaging. Furthermore, it proves that dollar cost averaging is not limited to stocks, but can be useful when trading other investment types.
Let’s assume you were to invest $5000 in VIOG over the course of 5 months, investing $1000 on the closest trading day to the first of the month. Starting May 1, 2019, your purchases would look like:
- May 1, 6 shares at $157.673 for a total of $946.04
- May 31, 7 shares at $148.54 for a total of $1039.78
- July 1, 6 shares at $157.1309 for a total of $942.79
- August 1, 6 shares at $156.67 for a total of $940.02
- August 30, 7 shares at $152.3982 for a total of $1066.79
With these purchases, you would own 32 shares at an average price of $154.23 and be left with around $65 in cash. If you were to use your $5000 principal at your initial purchase date, you would own 31 shares and be left with $112.14.
Now, if you were to sell your shares just a few months later, on December 31, 2019 with the price of $165.68, you would have a total of $5301.76 (not including the remaining cash). This would yield you a $336.34 profit, or 7.42% return.
However, if you were to sell your lump sum purchase on the same date, you would come out with $5136.08 (without remaining cash). This results in a $248.22 profit, or a 5.08% return. It is clear to see the positive effects of dollar cost averaging through this situation. Just by spacing your principal over a few months, you would’ve gained an extra $88.12, or 2.34%.
On the flip side, dollar cost averaging can hinder your gains. When looking at XSP, it is very clear that dollar cost averaging would limit your potential return. If you were to invest $1000 at the start of each month starting on October of 2019, over the course of 5 months this is how your investment would play out.
- October 1, 2019 – 30 shares at $32.65 for a total of $979.50
- November 1, 2019 – 30 shares at $34.04 for a total of $1021.2
- December 2, 2019 – 28 shares at $34.67 for a total of $970.76
- Jan 2, 2020 – 28 shares at $35.88 for a total of $1004.64
- Jan 31, 2020 – 28 shares at $35.54 for a total of $995.12
Through dollar cost averaging you would now have 144 shares with an average cost of $34.52. If you were to initiate a lump sum position on October 1, 2019, you would have 153 shares. As you can see, the lump sum position would give you more shares in this instance.
If you decided to sell your dollar cost averaging position 3 weeks later on February 21, you would now have $5304.96 (without remaining cash) for a total return of $333.74, or 6.7% gain. Pretty good right? However, if you were to initiate a position on October 1, 2019 you would have $5636.52 (without remaining cash), for a return of $641.07, or 12.8%.
If you look at these numbers, it is clear that the lump sum position doubles the return of the dollar cost averaging strategy. Of course these results are all situational, and I picked this example to emphasize my point.
Of course, if you were to look at a stock that has a downward trend, dollar cost averaging would limit your losses. As you buy when the price drops, your average cost will decline as well. Obviously, this would be better than a lump sum position as the stock continues to decline. This is how dollar cost averaging limits your losses.
This can also be a great way to decrease your average share price and increase your return when the stock rises back up. This serves as a dual effect of dollar cost averaging that is superior to a lump sum position.
One problem from dollar cost averaging has to do with commission fees. Of course, purchasing at multiple times increases the commission you pay. The bigger the amount you are investing at each time reduces the effect of commission prices on your return.
If you are investing $1000 at a time, you may have to pay up to $20 (half for the purchase and half for selling) in commission. Off the bat you are at a loss, and to make it up you must get a return of 2% just to break even.
If you went smaller, such as $100 per purchase, you now must gain 20% to break even. This severely hinders your gains. With this, it makes sense to invest with higher principals in order to limit this effect.
However, investing is a long-term game. Over twenty, thirty, even fifty years, the commission you pay will be returned in buckets from your diligent investing strategy. To look at some brokerage accounts and their trade fees, visit a previous blog titled “The 8 Best Self-Directed Brokerage Accounts for a TFSA”, or visit here.
Why Use Dollar Cost Averaging?
Other than the commission fees, I believe dollar cost averaging is a fool proof technique. As said by many, many, investors, “Time in the market beats timing the market”. As you continue your dollar cost averaging path, you will buy both when the stock rises and falls. I see this as a win-win. As you buy when the stock falls, you lower your average share price.
As you purchase when the stock is rising, you gain the returns of the bullish trend. As said earlier, dollar cost averaging limits the risk of your investment. This is beneficial for the average investor, or the cautious investor. Dollar cost averaging will not only limit your risk, but will help you sleep at night, knowing you won’t have to make quick decisions on your lump sum position.
Dollar cost averaging has its clear benefits, but is it as good as a lump sum payment? Well, as said by Ben Carlson from “A Common Sense of Wealth”,
“Research from Vanguard shows that, most of the time, investors would do best by investing a lump sum. The simple explanation is that markets tend to go up roughly three out of every four years.
Vanguard looked at a 60/40 stock/bond portfolio in the U.S., U.K. and Australia. It compared the performance of an immediate lump-sum investment over a year against 12 monthly purchases spaced out over the course of a year. The lump sum beat dollar cost averaging about two-thirds of the time.
On average, the lump sum beat the dollar cost-averaging strategy by an average of 1.5 percent to 2.4 percent, depending on the country. The results were even more pronounced for longer time horizons.”
So, if you are the gambling type, you have a 2/3 chance to come out on top of dollar cost averaging with a lump sum position. When thinking about the other third of the time, I could almost guarantee that the lump sum lost significantly more than dollar cost averaging. I say this from the idea that the average stock price would be lower from dollar cost averaging technique.
A great way in my opinion to implement dollar cost averaging would be to only dollar cost average under a certain price. With the high valuations in the market, I would utilize dollar cost averaging under my intrinsic valuation, or fair market value, in order to take maximum returns.
For example, Visa. I will limit my bias and not input my actual values. Let’s say in the current market, the valuation for Visa is too high for your liking. With the current bear market trend, you might want to buy where you see the valuation is fit. If you think a fair price is $180, then purchasing Visa when it dips below your fair price seems like a logical investment.
If you deem $180 as the fair value, your regular instalments below $180 will become a steal in value, and if the price rises above your valuation then you can be happy with your gains. Again, a win-win situation due to dollar cost averaging.
The Bottom Line
So, should you dollar cost average? Who am I to say. Of course, with all investing information, take it with a grain of salt and do your own research. I am definitely not a financial advisor, and none of my ideas should be taken as advice. I do think dollar cost averaging has a time and a place.
As you become older, I think dollar cost averaging is a great strategy as it mitigates the potential loss of your portfolio, which would be detrimental as you get older. I also think conservative investors would love this technique due to its safety. Especially during this current time of a highly valued and volatile market, I think dollar cost averaging is a great way to get started.
As many great investors have said, and what got me started in investing, “There will always be a reason to not be invested”. Starting by dollar cost averaging will help you learn your way around investing and is a great way to get started. As I said earlier, investing is a long-term game. Do your own research, and stay invested.