Moshe A. Milevsky, Professor of Finance, Schulich School of Business, York University, Toronto
Just a placebo
Using dollar-cost averaging (DCA) is a reasonable financial-planning strategy. But as an investment strategy, it doesn't make sense.You see,DCA is a bearish bet on the markets.
You're buying a few units now, in hopes you'll be able to buy more later when they get cheaper.
As such, DCA boils down to market timing, and any investment strategy that tries to outguess the market is predestined for mediocrity.
From an investment point of view, you are fooling yourself. If a person invests slowly as opposed to all at once, he can say, "Good thing I didn't go all in" if the markets move down. In reality, however, DCA didn't make the final outcome any safer — or even provide a better return.
Proponents of DCA say if you invest in markets gradually, you reduce the general level of risk in your portfolio. But having a properly diversified portfolio from day one lowers volatility and delivers higher returns.
To reduce risk, take less of it. If your client has the money now, pick an asset allocation he's comfortable with. Invest the money and live with the decision.
Planning and saving
The financial-planning aspects are something else altogether. If someone gets a bonus paid out as an extra $1,000 per month for a year, he has no choice but to use DCA as a financial-planning strategy, because he can't access the $12,000 all at once.
If that person does get $12,000 as a lump sum, though, he shouldn't wait to invest it. A far more efficient alternative is proper investment diversification across high- and low-risk assets.
One alternative is to place half into an equity fund and the other half into a money-market fund or GIC, if he wants to replicate the risk-and-return profile of using DCA.
Stick to a mix of stocks, bonds, cash, and alternative investments your client is comfortable with, as opposed to trying to guess whether current prices are high, low, or just about right.
The chart "Dollar-Cost Averaging vs. Lump-Sum Investing" below demonstrates why DCA can be beaten with a properly diversified portfolio, under a very hypothetical example to illustrate the tradeoffs.
Dollar-cost averaging vs. lump-sum investing:
Comparing the end-of-year outcomes
|Allocated to the Equity Fund*||Expected Wealth||Investment Variability|
* The remainder—not allocated to the Equity Fund—is invested in a one-year 5% GIC
If you place the $10,000 in a savings account and, using the DCA strategy, gradually invest it in the Canadian equity fund on a monthly basis, you can expect to have $10,750 at year-end (plus or minus $850). Two-thirds of the time your investment will be worth between $9,900 and $11,600.