The Learning Centre:
7 ways to make the most of dollar cost averaging.
Market fluctuations make it difficult for most investors (and even some professional investment managers) to determine precisely when to capitalize on an investment.
However, there is a useful investment technique called dollar cost averaging.
Dollar cost averaging means you’ll be investing a fixed-dollar amount at regularly scheduled intervals, while also taking into account market fluctuations. When the unit price is high, your fixed investment will buy fewer mutual fund units. When the price drops, it will, in turn, buy more units. In doing so, your average unit cost will be lower and you will be eliminating the risk of investing in the market at the wrong time. Plus, the longer you choose to take advantage of dollar cost averaging (such as a period of 5 to 10 years), the more lucrative it will prove to be.
Can this investment strategy really lower your investment costs and reduce the impact of market volatility on your portfolio?
The answer is, “Yes, but…” Dollar cost averaging can do all that it promises—but to maximize its benefits, you (as an investor) should do the following:
1. Start using dollar cost averaging as early as possible.
Dollar cost averaging instills the practice and discipline of investing regularly, and the earlier an investor learns this particular lesson, the greater the potential for gain over the long term. Also, it’s fine to invest smaller amounts using dollar cost averaging, so this strategy is very practical for education members starting out in their career and on a lower pay grid.
2. Invest consistently.
Whether investing a set dollar amount or a percentage of your income, do it the same way each time. Otherwise, you’ll end up saving at different ratios.
3. Remember to rebalance your portfolio.
You’ve worked with a financial planner to determine the mix of investments in your portfolio (or its “asset allocation”) that will help you meet your goals. Because different investments will grow or decline at different rates—one year may be good for stocks and bad for bonds—the different parts of your portfolio will also grow at different rates. To keep your original asset allocation, your portfolio should be rebalanced to reflect its original target regularly, say, once a year.
4. Keep calm, and carry on.
It may be tempting to abandon dollar cost averaging when the market is turbulent, but by doing so you’re reverting back to trying to time the market—exactly what financial advisors advise against. “One of the things that makes dollar cost averaging effective is the consistency”, says Educators Financial Planner Dan Martonfi. “So pick how you want to invest – weekly, monthly or quarterly—and stick with it.”
5. Remain engaged.
Just because you’re committed to a strategy doesn’t mean you stop being involved. For example, some investors establish a “stop-loss order” to sell an investment—an order which is triggered when the price of an investment drops by a predetermined amount (like 20% for example). A stop-loss order is more appropriate if you are buying shares of a stock, rather than investing in a dividend-producing fund or exchange-traded fund.
6. Have a lump sum to invest? Treat it differently.
You received a bonus or an inheritance that you want to invest. Studies have shown that a lump sum invested all at once produces higher returns (about two-thirds of the time) than money invested in 12 monthly instalments. The takeaway? Don’t take more than a year to invest all of that money. Keeping cash on the sidelines too long could mean missing out on the gains from putting those dollars to work.
7. Be aware of costs.
Because dollar cost averaging requires buying regularly, trading fees and transaction fees can add up. You can find out more about the costs of investing in mutual funds in The Learning Centre.