What is dollar cost averaging, you ask? This post will explain exactly what dollar cost averaging is, what the benefits and drawbacks are, and whether lump sum investing or dollar cost averaging comes out ahead.
In my humble opinion, to dollar cost average is the best way to invest your money into the stock market. It takes out the risk, it takes out the emotional turmoil of how the market is performing, which leads to indecision, and eventually leads to not investing and inaction.
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What is Dollar Cost Averaging
According to Investopedia, Dollar Cost Averaging is an investing strategy whereby if you have a lump sum to invest, you divide that lump sum into equal parts and invest that over time so that the intent is reduction of volatility of the purchase.
Let’s say you have $12,000 to invest. You could either invest that $12,000 all in one go, or you could divide it up to $1000 aliquots throughout the year.
Instead of trying to time the market, you invest at regular intervals (e.g. each month) with a regular amount (e.g. $1000) no matter if the market is up or down. if the market is up, you’ll be buying a smaller amount of shares for that $1000 available, if the market is down, you’ll be buying more shares with that $1000 available.
Dollar Cost Averaging Benefits
There are a number of benefits when you dollar cost average.
Minimizes emotions from affecting your investment portfolio. Dollar Cost Averaging helps you be systematic with your money. Because investing is 20% math and 80% psychology (as per Morgan Housel’s Psychology of Money book) dollar cost averaging helps the average investor trick their brain into investing regularly without putting your emotions into play. Hence, overriding your emotions when investing.
If we leave it up to our emotions to handle investing, we would be so paralyzed with fear (ohhh the market is down, I shouldn’t invest today) or too much optimism (ohhh the market is up, I should wait until it is down before buying these shares) that we wouldn’t act. Or if we do act, we sabotage our investment portfolio returns with our impulsivity, greed, and fear.
These are all natural emotions and ‘side effects’ of being human (and these emotions tend to be difficult to control or ignore). People tend to underestimate our ancestral lizard brains.
We are not as refined as we think we are, unfortunately.
Continues to strengthen investing as a habit. If you dollar cost average, you are continually contributing to your investment accounts. If you are regularly contributing to your investment accounts on a specific day (e.g. each pay day or the first day of the month) this is cultivating the seeds of discipline. Discipline to invest your money rather than blow it on an LV purse or a Rolex watch because you ‘deserve it’ is half of the battle with investing. You can’t invest money that you don’t have saved. So first, you need to save, and then you use that money you saved to invest.
Helps you stay invested. If you are dollar cost averaging, you are more likely to stay invested even during down days or down months or down years. As we all know, it’s not timing the market, it’s time IN the market. The market does go up but there are ups and downs in between. If you take your money out when the market is down and putting it back when the market is up you are timing the market and also not doing it very well.
Dollar Cost Averaging Downsides
Dollar cost averaging is not for everyone though. Here are some downsides of the DCA approach.
Math shows that lump sum investing is better. That being said, the downside of dollar coast averaging is that the math shows that lump sum investing is more advantageous compared to dollar cost averaging in terms of investment returns.
However, we are not all robots and you will have to know yourself and your personality and temperament- will you be comfortable lump sum investing or will you sleep better at night knowing your money is invested at regular interval? Personally, I prefer to dollar cost average a lump sum amount even though the math shows that lump sum is better.
Buying individual companies without thought into performance of the actual company. The other downside of DCA is if you are doing it regularly for individual equities without thinking about the company’s actual performance. If you continue to dollar cost average a company that has not been performing well, you may be digging yourself into a bigger hole.
Can be a tax headache. If you DCA very frequently, like weekly on ETFs (exchange traded funds) for example, you will have to keep track of your Adjusted Cost Base (ACB) and how much you are paying in commission when the time comes for you to sell your shares. Even if buying the ETFs are free with something like Questrade, there are still ECN fees or other small fees to keep track of.
Can be expensive depending on your investment brokerage. I use Questrade as my discount brokerage and purchases of ETFs are pretty much free (a few pennies here and there for more info on Questrade fees click here). Selling ETFs garner the regular commission. There are other brokerages out there that have free broad market ETFs, including specific ETFs that you can buy with Scotia iTrade, or buying the funds of TD e-series using TD Direct Investing, Wealthsimple Trade, and National Bank Direct Brokerage.
- Step by Step Guide on How to Invest your TFSA with Questrade
- Capital Gains Tax Rate in Canada
- Index Funds vs Mutual Funds: What’s the Difference
- Canadian Investing: Basic Tips to Get Started
- What is a LIRA?
Dollar Cost Averaging Calculator
There are easily dollar cost averaging calculators you can find online (for example, one by Percentage Tools here), but I personally like to have a bit more flexibility in how I dollar cost average. I don’t always buy the same ETFs but I do usually contribute the same amount of money each month.
For Canadian investors, Passiv helps you calculate how much to rebalance or dollar cost average if you want to rebalance at the same time. Passiv Elite is free to use for Questrade users for the first year and it provides a lot of insight into your portfolio.
In this example below, it will provide you with the recommendations of how many shares to buy with the existing cash you have depending on your weighting preference.
Here’s my Passiv review.
Passiv would normally assume that you would want to be 100% invested, but you can use Cash Management and apply two rules:
- Retain at least– allows you to keep a fixed amount of cash in your portfolio
- Allocate at Most– allows you to set a maximum amount of cash invested with each trade
To do this, here are instructions on the Cash Management Rules from Passiv.
First, you click on Portfolio Settings in the specific Portfolio you want to set rules on.
Then you click on Add Rule:
If you already use Questrade and you want to sign up for Passiv Elite, it’s free!
Dollar Cost Averaging Vs Lump Sum
As mentioned earlier, lump sum investing comes out ahead of dollar cost averaging.
According to this Forbes article, Vanguard did a study in 2012 looking at DCA vs lump sum investing over 10 year periods from 1926 to 2011. They found that 2/3 of the time, lump sum investing trumped dollar cost averaging in terms of portfolio increase.
Vanguard also looked at losing money. DCA resulted in less portfolio compared to lump sum investing. The Vanguard study found that lump sum investing decreased in value 22.4% of the time, whereas dollar cost averaging decreased 17.6% of the time.
That being said, the difference is minimal, a few percentage points (like 2%) over a 10 year period.
So in summary, you do you! Investing regularly is already a great habit and whether you dollar cost average or lump sum invest should be based on your investing temperament and what would help you sleep better at night.
Dollar Cost Averaging Example
Now that we know about the pros and cons of DCA and how DCA compares to lump sum investing, here’s an example of how to dollar cost average.
Let’s say you have $100 to invest each month and you want to invest it in a Vanguard Canada All in One ETF (one that doesn’t require rebalancing) like VEQT. Or even VGRO ETF.
- In January 2021 VEQT is $31.14 per share. With $100, you can buy 3 shares.
- In February 2021 VEQT is $32.24 per share. With $100 you can buy 3 shares.
- In March 2021 VEQT is $32.65 per share. With $100 you can buy 3 shares
- In April 2021 VEQT is $34.00 per share. With $100 you can buy 2 shares
So in total, you have 11 shares of VEQT at an average cost of $32.37.
As you can see if you had $400 and bought 11 shares of VEQT in January you would come out more ahead portfolio wise, but the ritualistic nature of DCA and investing regular pre-determined amounts helps support the dollar cost averaging approach for people who are not attracted to investing and saving money.
Tracking For Tax PUrposes
Finally, let’s look at how dollar cost averaging affects what you report come tax time. It’s not a big deal when you are purchasing ETFs but if you sell them, you will have to keep track of your adjusted cost base. The adjusted cost base is the price you pay to acquire an asset.
You’ll have to keep track of all the purchases you have made and how much your commission was and your purchase price to calculate your capital gains.
As mentioned, that’s one of the down sides of dollar cost averaging. if you are buying an ETF or equity so frequently you’ll have lots of transactions to review when you sell. I suppose this bit of tax headache is eliminated or reduced if you have a completely commission free brokerage.
Hopefully this helps you understand dollar cost averaging a little bit more for you to decide whether this investing approach is right for you.
Are you a fan of dollar cost averaging?
GYM is a 30 something millennial interested in achieving financial freedom through disciplined saving, dividend and ETF investing, and living a minimalist lifestyle. Before you go, check out my recommendations page of financial tools I use to save and invest money. Don’t forget to subscribe for blog updates, a free dividend yield spreadsheet, and the free Young Money Bootcamp eCourse.