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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.

OK, I’ll admit my past investments in mutual funds are good examples of how NOT to evaluate and choose which funds to buy. However, by investing unwisely I have learned a few lessons that I will share with readers. I also encourage you to share your own mutual fund buying experiences, good or painful, with a comment. There’s always more to learn! This article describes some methods to help evaluate a mutual funds’ risk and performance before choosing which fund you want to buy.

Remember, while reading, that mutual funds are not only for investing in the stock market. They are great tools for investing in bonds, bullion and other types of assets. For more details, please skim The Types of Mutual Funds, Why They’re Good, and Quick Buying Tips.

Evaluating Mutual Funds

Take a Quick Look by Starting with the Fund Facts Sheets

Fund Facts are Your “Friend”

I’m never sure I trust employees of the government or of a financial institution when they say they want to be my friend. I mean it’s nice but I’m always a bit suspicious. I feel the same way about the required Fund Facts sheets provided by mutual fund issuers. It does provide a lot of useful information in a consistent format and in fairly readable English. However, I wouldn’t rely solely on the Fund Facts sheet when deciding whether to invest in a fund.

What Does the Fund Facts Sheet Identify?

Performance History
How did the fund fare in 2002 and 2008? The stock market as a whole did poorly those years. The TSX Composite fell about 35%. The S&P 500 in the US dropped about 32%. Bond and precious metals funds should have shown reasonably good results those years as investors fled from stocks into perceived security. Did the fund do better or worse than the market average?

Investments
The Fund Facts sheet should list the top investments of the fund and describe the types of investments held by the fund.

This can be a very important section to review!

For example, you might think a fund called the BMO Canadian Equity Class Series A Fund would be invested in Canadian Equities, right? Yet in the description of “What does the fund invest in?” BMO states “The fund may invest up to 30% of the purchase cost of the fund’s assets in foreign securities.” In other words, the fund could go and buy stocks in, say, businesses in Greece and Spain if it wanted to. Canadian, eh?

Costs
The costs section includes the cost to buy the fund including any commissions or fees. It also includes the ongoing costs of owning the fund including the MER and whether the MER pays trailer fees. (Trailer fees are often annual and are paid to the person who sold you the fund for as long as you hold the fund.) If there is a fee to sell the fund (called a deferred service charge or a declining sales charge) it should be reported here, too.

Risk
The sheet gives an approximation on a scale of 1 to 5 for how risky an investment in the fund is.

The problem is there is quite a difference between what the industry considers risky (hedging; options; leveraged investing; penny stocks) and what most investors like me consider risky (losing 20% of the funds value if the market sways). I think you shouldn’t put too much faith in this chart as I think most stock funds are going to be listed as “medium” risk.

Ellen Roseman of the Toronto Star wrote a great article on this called “Is a fund that drops 60% only ‘medium’ risk?”

Get Under the Hood: Look at the Core Holdings

The names of mutual funds often seem to have been selected by a random phrase generator pre-loaded with words like “performance; high; income; dividend; yield; growth; security; guaranteed“ The names often don’t actually reflect what is held by the fund. The only way to know what you’re really buying a share of is to look at the holdings of the mutual fund.

For Canadian funds, the top holdings are usually easy to find in the Fund Facts summary for the product.

Be Careful because Fund Names Don’t Match Fund Holdings
For example, the RBC Global Dividend Growth Fund Series A is actually invested 63% in American equities. [UPDATE: In February 2014 it was down to 35.6%.] If you bought this fund assuming it was investing primarily outside of North America you’d be wrong. Look at the details, not at the name.

In another example, the RBC Asian Equity Fund Series A is 15% invested in Australia. [Update: In February 2014, still 14.1% in Australia.] Now I don’t know for sure what they teach now, but when I went to school Australia was NOT part of Asia. Names can be misleading.

How Will You Make Money from the Mutual Fund?

One thing I didn’t consider well enough before buying a mutual fund was how I would make money from owning that fund. I was used to funds that paid distributions that were re-invested as additional units. I honestly didn’t look closely at that aspect of this fund before I bought it.

The fund, like many of my investments, promptly tanked as the price of oil halved. I sighed. The oil patch and I have a long history and I knew that given enough time and patience, petroleum stocks rebound. I’d just have to wait since I still considered the companies the fund was invested in were good choices for the long term.

Imagine my shock when I realized, though, that this particular fund is purely a capital gains play. It doesn’t make any distributions, ever. You buy it, wait till it appreciates in value, then sell it. The only money you make is the difference between your buy and sell prices.

I *hate* having money invested that shows no annual return. If a stock pays at least a small dividend, I feel better if I have to wait for a market rebound. With this fund I had to either sell and eat the capital loss or hold and lose the opportunity value of that money while I waited for a rebound (and hopefully an eventual uptick.)

I learned my lesson that time. I don’t buy anything now that doesn’t have some form of annual distribution. I’m just not wired to handle dead weight investing.

Look at the Fees and Commissions Including the MER

Almost all mutual funds have a Management Expense Ratio or MER. The MER tells you what percentage of the fund is used to pay costs each year. A typical MER might be anywhere from 0.35 to 2.5%. That’s quite a difference. It means you are paying $17.5 to $125 per year in fees to own $5000 of a fund.

In a good year, the MER is subtracted from the earnings of the fund before the profits are distributed to the fund owners. Profits may be distributed as income or as an increased value per unit of the fund or as an increased number of units in the fund.

In a bad year, however, the fund may lose money. then the MER is subtracted from the actual value of the fund. That’s right; you have to pay the MER even if the fund loses money.

If the markets go down and a fund loses 15% in value and the fund has a 2.5% MER, then the real loss passed on to the fund’s holders is 17.5%!

According to various studies, Canada has some of the highest MERs for mutual funds in the world. Check closely how much you would be paying before purchasing a fund.

Some companies offer funds with comparatively very low MERs. These include the TD e-series funds available only to investors with an online TD Canada Trust EasyWeb account or a TD Waterhouse Discount Brokerage account. (Vanguard is now offering some very low MER ETFs in Canada, too.)

Look at the Redemption Terms

For many mutual funds you are locked in to your purchase for 90 days. If you try to redeem (sell) your fund holdings before 90 days you may have to pay a very large fee. Check the prospectus for information on early redemption.

However, funds may have longer or shorter holding requirements. For example, at the time this was written, there was no minimum holding period required for the Renaissance High Interest Savings Account mutual fund, ATL5000. This fund is encouraging investors to “deposit” cash like in a daily interest savings account while waiting to invest elsewhere.

Look at the “Loads” Front End, Back End, Deferred Sales Charges or Declining Sales Charges

Some mutual funds still charge you a fee to buy them (a front load) or to sell them (a back end load or DSC.) It really should not be necessary to pay a fee just to buy or sell a mutual fund. Check whether there are any loads or DSCs and don’t buy if there are.

Look at the Trailer Fees for Mutual Funds

This fee is trickier to assess. A trailer fee is paid to the person who sold a mutual fund to a customer. The trailer is often paid annually for as long as that customer holds the fund.
This is not great, but it wouldn’t be so bad if the trailer fee was identical for every mutual fund. It’s not. Some funds pay larger trailer fees.

Now if you are the person who sells mutual funds and you could sell either of two funds and one will pay you 1% of the sale price per year forever, and the other will pay you 0.25% of the sale price for three years, which one will you naturally feel inclined to sell?

The problem is that as the customer we want to buy a fund with low or no trailer fees. So it’s up to us to check various fund choices and be aware that the salesperson might have a bias towards a fund with a higher trailer fee.

Ask yourself: who am I trying to make money for, myself or my salesperson?

Did you know that you pay trailer fees to your brokerage even if you have a self-directed brokerage account? That’s right, even though YOU are the person analyzing and recommending to yourself which mutual funds you should buy, you are paying your brokerage a trailer fee. There have been a few attempts to change this but at most brokerages the practice stands.

Comparing Apples and Cows

Two funds may sound the same and have nothing in common. This is where it’s important, yet again, to look at what the fund is actually investing in.

For example, in early 2013, the BMO Monthly Income Fund is invested (at this time) 1% in cash and 51% in Canadian equities. The Fidelity Monthly Income Fund is invested 10% in cash, 24% in Canadian equities and 16% in foreign equities. Despite the very similar names they are not invested in comparable ways. Differences in their earnings could be due to differences in the risks they take and in the types of assets they hold.

Get Independent Advice Before Buying Mutual Funds

If you’re going to invest in mutual funds you should be looking for impartial, third party advice on which funds to buy. If you go to a bank, they are almost sure to only try to sell you their own line of mutual funds.

Where can you find impartial advice? For years, Gordon Pape used to write an annual book comparing funds. He only made money from you buying the book whether or not you ever bought any funds. Now, his business runs an online newsletter called the Mutual Funds Update. (http://www.gordonpape.com/ )There are probably other newsletters out there too. Again, the newsletter publishers do not get a trailer fee because you don’t buy anything from them.

Other sources include reading financial newspapers and magazines.

You can also hire a fee-only financial planner. They get paid by the hour or project and do not receive any commission for what you purchase, because they do not actually sell it to you. It may be hard to find a fee-only planner, though, that is interested in helping clients with a low value portfolio.

When are Mutual Funds Worth Buying and Which Ones Should You Pick

Bond Funds

Buying units in a bond fund requires less capital investment for more diversification with lower purchase commissions than buying individual bonds yourself. It also provides active management. What’s not to like?

Compare the fees for ETFs vs mutual fund bond funds. Also compare the performance, though.

I’d take a close look at the PH&N bond funds, including their total return bond fund. There may be equally good bond funds out there elsewhere, too. I’m not an expert.

Disclosure: I do own some holdings in a PH&N bond fund but it is not one available through discount brokerages only through company pension plans. And yes, in 2013 it lost money.

High Interest Savings Account Funds

The daily interest savings account mutual funds provide a convenient place to park cash in some discount brokerage accounts. For example, at CIBC Investor’s Edge you can put cash into ATL5000 with a minimum $1000 deposit. At other brokerages it isn’t as easy. For example at BMO InvestorLine there is a minimum deposit of $~~25,000!~~ [UPDATE: As of April 11, 2013, BMO InvestorLine is offering a BMO HISA with a minimum deposit of $5,000.]

I have used ATL5000 at Investor’s Edge, RBF2010 at RBC Direct Investing and AAT770 ~~DYN500~~ at InvestorLine successfully.

Precious Metals Funds

It’s difficult to buy and hold precious metals safely. If you want precious metals in your portfolio, it’s worth considering buying them through a mutual fund or ETF. Some funds like the BMG Bullion fund (BMG 100) hold real physical metals for you in secure storage.

Personally, I don’t own any precious metals and I have no idea in which fund it would be best to invest.

Index Funds

If I was investing in equities, I personally would choose a fund that matches a large comprehensive index, such as the TSX Composite for Canadian equities, the S&P500 for US Equities and something equally broad for other international equities. Any analysis of which fund to pick needs to look closely at the fees (especially the MER) and at the actual holdings to make sure it is replicating the index. You must compare the ETFs and the mutual funds to ensure you are getting the best options.

Remember, at many brokerages you will pay each time you purchase or sell an ETF, but you will not pay a commission to purchase or sell a mutual fund. You generally can also reinvest mutual fund distributions in fractional units, but you usually cannot hold fractional units of an ETF. Ideally you’d like to find a mutual fund that holds the same index as an ETF for the same or lesser MER. Then you could have the lowest fees and the best re-investment policy.