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.
If you allocated $4,960 to the mutual fund, and the remainder to a money-market fund, however, you could expect to receive the same $10,750 as DCA.
But the variability of your investment will be much lower, marplus or minus $744 compared to plus or minus $850 in the DCA approach. You can generate the same expected return as DCA with lower risk by roughly splitting your money between an equity fund and a GIC.
During a recession
People tend to get scared during recessions and may want to pull their money out to reinvest a little bit at a time. But switching to DCA won’t help. Dramatic reactions, such as pulling out of the market, only limit your returns.
Instead, reiterate to clients why the asset allocation you chose was suitable. Give them enough time to get comfortable with that allocation so they stick with it over the long run.
This behavioural tweak is superior to DCA’s automation.
Peter Andreana, CFP, CSWP, FMA, EPC; Partner at Continuum II Inc., Burlington, ON.
Force of habit
DCA allows clients to make saving and investing habitual.
It’s your job to make sure clients index their saving levels to inflation. If a client saves $100 a month, make sure she increases
it to $103 next year, and $110 in a few years.
When clients buy investments monthly, they average out the purchase price, and eliminate the emotion involved in when and how
much to purchase.
If they purchase investments once or twice a year, they could be buying based on emotion — that’s dangerous. Also, squeezing in a lump-sum RRSP contribution at the end of February could mean they’re buying at the most expensive time of the year.
DCA has valuable psychological and behavioural benefits. When people actually have to make the decision to invest and actively maintain their portfolios, rather than depending on the automatic withdrawal from their bank accounts, greed and fear kick into the decision-making process.
Everyone is in danger of investing emotionally. Over the long term, buying on emotion can significantly reduce a client’s rate of return.
Investors can experience a dramatic decrease in rates of return by simply missing the 10 best days in the market, for example. Keeping the dollar amount constant solves this problem.
The only reason (besides inflation) we would increase or decrease a monthly contribution is if an investor’s goals have changed or if she wants to make changes to her retirement plans.
Often, once they have their mortgages paid off, many Canadians consider purchasing a cottage or second property. Once we run this through the financial plan we can quickly ascertain if this is doable, or will it have a negative impact on other goals like retirement.
It doesn’t work both ways
In reverse,DCA can be detrimental. If a client needs $50,000, she should not take out a monthly amount based on retirement needs.
Instead, if she needs to withdraw invested funds, she should do so based on units. In a good market, generating $5,000 a month could take 5,000 units, but in a bad market you could need 6,000 units to generate the same $5,000.
In this scenario, she’d be burning through investments significantly faster than planned in down months.
The only way to have your money invested in the markets and live off those funds would be to fix the number of units withdrawn each month. So, in this more favourable scenario she would withdraw 5,000 units a month and in good markets, she would cash out $5,000, while in bad months, maybe $4,000.
Most clients don’t know you shouldn’t withdraw from and treat invested funds like a chequing account. Instead of taking funds out of the market, it’s better to build different types of income streams three-to-four years prior to retirement that you can use to cover expenses.
Once in retirement we flow funds down the chain from the balanced portfolio to the conservative portfolio. Funds from the conservative portfolio then move down to the laddered GICs, and the GICs go into cash when they mature.
During a recession
DCA makes a ton of sense during volatile times, since there’s no emotion involved in financial decisions. It’s automatic.
Clients don’t have to make independent decisions based on what’s happening in the markets that day.
In volatile times, it also has the benefit of continued investing through good, bad and ugly times. Someone not using DCA would need to think about when they’re going to invest and how much.
That typically means when the markets get really ugly, they’re too scared to invest — even though that might be the very best time.