Dollar Cost Averaging

With the “New Normal” looking like it means that it is commonplace for the markets to move plus or minus 2% in a single day of trading, it can be understood if an investor asks him or herself about when money should be put to work.

I would advocate for almost always.

Dollar Cost Averaging is a simple average. If you continuously buy a certain security over a period of time at different prices, the average cost is what you base your profit or loss upon. It is basically putting your portfolio on auto-pilot, which can remove some of the emotions of investing, and letting your investment build over time, which removes the stress of trying to decide when to buy.

To illustrate the point I created two simple portfolios. I randomly selected a low-cost Canadian index fund, and selected January 2007 as the starting date of the portfolio, which gives us three and a half years of data.

The assumption is that two investors had $5000 to invest at that time. Investor A put all $5000 in the Canadian Index fund; Investor B put $900 in to start, put the remaining $4100 in a high interest savings account, and set up an automatic withdrawal to invest $100 per month from that account.

After 3 and a half years where are our investors?

Investor A is currently just above par with a gain of 0.9%, which is only because of re-invested distributions, which were paid annually.

This investor probably would have encountered a good amount of stress as he watched his holding drop 50%, from a high of over $6000 to just above $3000.

And Investor B?

By investing $900 to start, and $100 every month, this investor would also have invested a total of $5000, but she would be over 5% ahead because of dollar cost averaging, reinvested distributions, and interest.

This is because she would have been buying small amounts of the fund through good times and bad, smoothing out the average purchase price.

She would also have been receiving interest on the cash she had in the high interest savings account, which was slowly being depleted over the three and a half years.

I suspect Investor A would also have had less stress to deal with through the recession, as her portfolio would have been down about 20% at the trough (the invested capital would have been down 30% – from $3000 to $2000 – but she would have had about $2000 sitting in cash).

I’ve written before about the investing lessons learned from Aesop. He brings us wisdom again today in the form of slow and steady wins the race.

There will be times when it may seem like indexing and dollar cost averaging is a losers game (at one point, Investor A had over $6000 to Investor B’s $5500, for example), but I am confident that over the long-term it is the way to smoothing fluctuations, lowering stress, and increasing your net worth.

Advertisements

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s