Learn dollar cost averaging

After a couple of years of low market volatility, the bigger swings started up again earlier this year.

The thing is though; market volatility is normal and need not be feared. You should however plan for this movement and make sure that your portfolio is built to accommodate it. 

One simple technique for adapting to volatility is the use of dollar cost averaging (DCA).

In the simplest form, a DCA strategy is one that has you buying into the markets on a regular basis for a fixed amount, regardless of market conditions.

The “cost averaging” part of the equation is a consequence of buying less of a stock or fund when prices rise and more units when prices fall, averaging out the cost per share or unit over time.

Nobody wants to invest a hefty sum of money right before the market goes down and see their value drop in the first few months. Ideally, you’d like to put the money in right before the market has some strong gains.

By using a DCA strategy, you don’t need to try to predict what the market will do in the short term, a prediction that nobody can make with absolute certainty. Instead you will gradually and continually add to your portfolio.

Many investors unknowingly "dollar cost average" by default if they put a regular monthly amount away into their RRSP or TFSA.

There is no question that this is the preferred way to put money away and save for retirement since you can take advantage of the longer-term time horizon without worrying about picking the right time to invest.

But what should you do if you suddenly have a larger sum all at once? 

The lump sum might come from the sale of a home, an inheritance or even an employment buyout.

While the desire to put all the money to work right away might sound good, you need to equally consider the current market conditions and risks involved. It may be far safer and less stressful to implement a shorter term DCA strategy and put say 20 per cent of the money into your chosen investments each month for the next five months.

In some market conditions, it might make more sense to put all the money in at once, particularly if the investment time horizon is longer. Each situation should be independently evaluated to see what makes the most sense.   

On the withdrawal or retirement income side of the equation, a reverse DCA strategy might also be a good idea.

Let’s assume you pull $50,000 out of your RRIF each year.

If you pull the money as a lump sum every July 1, the timing might help or hurt you. If the markets go up in the first two quarters of the year and then drop back down for the rest of the year, your July 1 timing couldn’t be better.

But if the markets have a rough first half of the year before recovering and growing into year end, your timed withdrawal could eat away at a fair bit of capital. 

The same retiree could instead elect to pull $4,167 each month which would spread the market timing risk out and create an average cost of sales prices for the given year. 

Statistically speaking, putting in or taking out a lump sum all at once will outperform a DCA strategy over time – roughly to the tune of two out of three cases.

But that doesn’t necessarily mean it is right for you.

You need to also consider the “sleep soundly at night” factor, which often is worth far more than a little bit of extra returns.     

This article is written by or on behalf of an outsourced columnist and does not necessarily reflect the views of Castanet.