There is ongoing debate about the pros and cons of Dollar-Cost Averaging (DCA). This is a process where an investment is made, at regular intervals, regardless of an asset’s price.
For example: Emily wants to contribute to her TFSA as part of a 5-year plan to save enough for a condo down payment. She has authorized her financial institution that on the 15th of every month an electronic funds transfer will move $100 from her chequing account to invest in a balanced global mutual fund.
The key advantage of dollar-cost averaging is that it reduces the effects of investor psychology and market timing on a portfolio.
There are several components to this strategy. First, this investment performance may improve in the long term, but only if the investment increases in price. The strategy cannot protect the investor against the risk of declining market prices.
The key advantage of DCA is that it reduces the effects of investor psychology and market timing on a portfolio. By committing to this approach, investors can avoid making counter-productive decisions out of greed or fear, such as buying more when prices are rising or panic-selling when prices decline. Instead, dollar-cost averaging compels investors to focus on contributing a set amount of money each period while ignoring the price of each individual purchase.
Another key benefit is that for those who do not have a significant lump sum at the outset of their plan, it is an effective way to ensure that money regularly goes into their investment strategy.
Dollar-cost averaging is not a solution for all investors.
Dollar-cost averaging is not a solution for all investors. Trading costs may add up. This strategy still requires you to do your research and track your progress. If the original investment decision was faulty, you could end up investing steadily into a losing investment.
Another disadvantage of DCA is that markets tend to go up over time. This means that if you invest a lump sum earlier, it is likely to do better than smaller amounts invested over an extended period.
Research from the Financial Planning Association and Vanguard found that over the very long term, dollar cost averaging can under perform lump sum investing. Lump sum investing beat dollar-cost averaging 66.66% (2/3) of the time. Therefore, you’re better off investing a lump sum as soon as possible.
The bottom line is that dollar-cost averaging could be a good approach for an investor who has a solid investment plan, would like to avoid behavioural biases of being influenced by market fluctuations and wants to follow a passive pre-set approach.
On the other hand, if you have the funds, a solid investment and are in a rising market, you may experience superior results from investing in a lump sum.
As with all strategies, each person must align their individual situation and process to achieve their specific long-term goals.
Just getting started with investing or wanting to learn more? Register for our Cash Flow Connections Workshop Series, a 6-part lunch hour webinar series starting February 9-March 16, 12pm-1pm on Zoom.