What Is Dollar Cost Averaging and Why Is It Useful?

Dollar cost averaging isn’t talked about as much now as it was when The Wealthy Barber was first published. That doesn’t mean this strategy isn’t still useful. Yesterday, the Dow Jones Industrial Average set a record high beating the last high set in October of 2007. You remember that one, right? It came just before the Dow began its long slow fall to half its value by April 2009. People who bought their stocks in October 2007 probably wished they had followed a dollar cost averaging strategy instead.

Timing the Market to Buy Low and Sell High

Ideally investors would like to time their purchases and sales so that they are buying when prices are low and selling when they are high. The problem is how do you know what “high” and “low” are until after the fact? People have invented all sorts of complex mathematical models to help them predict the highs and lows, but frankly no one seems to be using them very successfully. The last I checked all the world’s billionaires got their money by other means.

Is It Better to Buy a Stock All at Once or In Stages?

So should an investor just press the Buy button and invest all they own on any given day? They certainly can. And then they have a 50/50 chance that the price of that stock will go up or, unfortunately, down.

Another strategy would be to take the money to be invested and divide it into parts. Then, at some interval, the investor would buy one part’s worth of the stock. For example, the money could be divided into 12 parts and on the 15th of each month, the investor could buy 1/12 of their total purchase of the stock.

Each time the buyer invests, the stock price could move up or down away from the purchase price. In theory by investing the money over several spread out intervals, the price should sometimes go up after some of the purchases. (Of course, it is also more likely that the price will go down after some of the purchases.)

What is Dollar Cost Averaging?

Spreading out the purchase into several orders at spaced out intervals is called dollar cost averaging. It is meant to reduce the risk of making an entire investment at a point when a stock’s price is high and about to fall.

When Does Dollar Cost Averaging Not Work?

Dollar cost averaging does not guarantee you will make the maximum profit. You would optimize your profit if you could buy at exactly the moment the stock was at a low price from which it was about to steadily increase in price.

With dollar cost averaging, you might buy a portion of your investment at this lowest price point. However, you would also buy some of your investment at higher prices.

You do lose some potential gains by using dollar cost averaging. (Unless, I suppose,  you buy a stock that is steadily declining in price each time you buy and which eventually goes down to extinction. Hopefully you didn’t use that strategy during the dying days of, say, YLO. If you did, you have more to worry about than the loss of the potential gains.)

Why Commissions and Fees Deter Investors from Using Dollar Cost Averaging

One drawback of dollar cost averaging is the increased cost to purchase a stock if a commission or fee must be paid for each trade. For example, if you bought $10,000 of BCE in one order, you would pay your usual brokerage fee of $4.95-$40 for the fill. If you bought the same $10,000 of BCE in 12 monthly orders, you would pay 12 times your usual brokerage fee for a total of $59.40-$480. The extra costs make many investors resist using dollar cost averaging.

Mutual Funds May Permit Free Dollar Cost Averaging

Many no-load mutual funds are available which do not charge any fee or commission for purchasing units. It would be easy to invest in these mutual funds at intervals to permit dollar cost averaging. Be careful of the other fees charged for mutual funds, however, as these may be so high that the benefit of dollar cost averaging is insignificant by comparison.

ETFs May Permit No-Fee Dollar Cost Averaging

Some ETFs available through Scotia iTrade, Qtrade and Discount Brokers can be purchased with no fee or commission charged. These ETFs would permit easy dollar cost averaging. At this time, Questrade is also offering no fees or commissions on purchases of all the ETFs it offers. This would also be beneficial. As with mutual funds, though, check the other fees charged by the ETF before buying. The other management and maintenance fees may be so high that there is no real benefit to dollar cost averaging.

A DRIP May Provide Free Dollar Cost Averaging

For stocks, mutual funds and ETFs, using a Dividend Reinvestment Plan or DRIP may permit free dollar cost averaging. Each time the dividend is used to purchase new shares or units, it does so at the price at that time. Given the usual relatively low rate of distributions offered by stocks and funds (usually less than 10% per year) this is not going to provide full dollar cost averaging for the holding, but it will provide some protection and for free.

Accidental Dollar Cost Averaging

Many investors don’t have a large sum of money ready to invest. Many, instead, invest a small amount each two weeks or month as it is earned. By default, these investors will probably end up using a dollar cost averaging approach as they will invest a small equal amount each month. If they don’t buy the same shares or units each month, however, they are not really dollar cost averaging.

When Should You Use Dollar Cost Averaging?

If you are afraid to start investing in case the markets start to slip, dollar cost averaging may help you overcome your fear and start buying. If the money is not earning anything while you dither about whether to buy, dollar cost averaging may be a helpful tool to get some of your money back into investments.

If you think the markets are priced highly and yet you don’t want your money parked in a cash account at a negligible interest rate, dollar cost averaging may also provide you with the solution you want. By investing in slow but steady stages you will get the money at work again without risking putting it all in when the market is at a peak.

Is the Dow Too High Today?

Is anyone else a bit nervous of the Dow closing so high? I really don’t want to watch another two year market slide. Maybe I’ll have to use some dollar cost averaging myself as I put this year’s TFSA money to work.

Related Reading

Join In
Do you use dollar cost averaging to try to soften the market swings? Or do you try to time the market waiting for a pullback to invest? Please share your experiences with a comment.

Leave a Reply

Your email address will not be published. Required fields are marked *