08 May Embrace volatility with dollar-cost averaging
Roy the Barber, the folksy hero of Canadian personal-finance tome The Wealthy Barber, is a big fan of dollar-cost averaging (DCA).
The strategy, Roy tells his protégés in David Chilton’s 1989 bestseller, “‘is as close to infallible investing as you can get. It genuinely slants the odds in an investor’s favour.’”
Chilton’s book is credited with kick starting generations of Canadian investors into saving for retirement, urging them to save at minimum 10% of their earnings and watching that money grow through the twin miracles of compound interest and DCA. And while it’s difficult to criticize the merits of a regular savings plan (not to mention compound interest), it turns out that Roy the Barber may have exaggerated the merits of DCA.
Dollar-cost averaging is defined as “buying a fixed dollar amount of an investment on a regular schedule, regardless of price,” says Dustin Barrow, a certified financial planner with Abacus Wealth Management Inc. in Edmonton.
The “cost averaging” part of the equation is a consequence of market volatility: investors buy less of a stock or mutual fund as prices rise, and more as prices fall, averaging out the cost per share over time.
Stephanie Farrow, a certified financial planner at Farrow Financial Services Inc. in Belmont, Ont., says DCA helps investors—in particular people with longer time horizons—weather the storms of fluctuating prices. “No one wants to look at a statement and see that number is going down, but there’s a silver lining with DCA. If prices go down, who cares? You just bought a whole bunch at a discount. And you can see the value growing over time.”
But is DCA really the miracle that Roy the Barber claims it is?
Partly, it depends how you define it. For the average investor, DCA is not so much an actively chosen strategy than the logical consequence of another Wealthy Barber maxim: that of “paying yourself first,” or automatically diverting a percentage of your income to savings so that you (theoretically) don’t miss that cash and learn to live within your means while also saving.
Further, many people don’t have a lot of money to invest beyond that automatic percentage, so they default to DCA, buying as much of an equity or a fund as they can with the money available to them at the time. (Of course, they could also regularly park cash in an RRSP or a money market fund, and buy specific securities on their own timetable.)
The key is that the investment is automatic, so investors aren’t faced each month with the decision of whether to put funds aside. It must also be consistent so funds accumulate over time. In that sense, it’s a great strategy—especially, notes Barrow, if contributions rise along with earnings.
Farrow agrees. “I think that sometimes people put off starting a nest egg until they have more money to invest. But in reality, those little bits and pieces tucked away at regular intervals are so advantageous. It really builds over time.”
A more orthodox definition of DCA, though, involves deciding how to invest larger sums of cash, such as a bonus, an inheritance, an insurance payout, the proceeds from a business sale or some other windfall. In these cases, the question is whether to invest all the money in a lump sum, or to dollar-cost average it into the market over months or years.
Barrow, for example, recalls working with a client who had about $300,000 to invest after the sale of a rental property. “It was around 2011 or 2012, when there was a lot of uncertainty about Portugal, Ireland, and Greece,” he says. “The client had some apprehension about putting all of it into the market at once. In the end, we split the funds into four parts, and put in $75,000 in each quarter.”
Farrow used the same strategy with a client who had about $500,000 to invest right around the financial crisis of 2008 and 2009. “We invested it over the course of 24 or 36 months. And that was a huge benefit. She definitely had to ride the curve down, down, down for a while. But when the markets swung back up, her portfolio really rebounded beautifully.”
Dollar-cost averaging a large lump sum, say both advisors, made sense given the volatility of the markets at the time and the lower risk tolerance of those particular clients. In general, though, those kinds of cases are exceptions, rather than rules. Especially in bullish years, says Farrow, most of her clients with a lump sum are ready to jump in all at once. Barrow, too, tends to prefer investing the entire sum as soon as possible: “It’s that saying: it’s ‘time in the market,’ not ‘timing the market,’” he says.
Their instincts are correct. In July 2012, Vanguard released a paper called “Dollar-cost averaging just means taking risk later,” which reported that a lump sum approach outperformed a DCA approach approximately two-thirds of the time over a variety of portfolios. These results are consistent with earlier studies, including a landmark 1979 Journal of Financial and Quantitative Analysis paper titled, “A Note on the Suboptimality of Dollar-Cost Averaging as an Investment Policy.”
Does that mean DCA is always a bad choice?
Hardly. After all, the strategy may win at least a third of the time, especially during volatile markets.
“The psyche of the investor has a much bigger role than people realize,” says Farrow. For a beginning investor, or one with a low tolerance for risk, DCA offers “a whole suite of psychological advantages” that could be the difference between investing at all or sitting frozen on the sidelines of the markets, waiting for a mythical best time that might never come.
In the end, she says, the answer involves finding the sweet spot between what makes sense actuarially and a client’s “personal, sleep-at-night factor,” says Farrow. “DCA lets people take baby steps towards investing, letting them rest at night knowing that they’re taking advantage of the strategy even as the numbers on the statement go up and down. I’m a really big believer in it. And I wish that more people would actually just get started with it.”
To read this article by Advisor to Client online, CLICK HERE. If you have questions be sure to contact Harry Perler or David Olejnik.