During the past year in Canada, both domestically and internationally, we entered 2016 with our national economy on the verge of recession led by a drastic slowdown in Alberta’s economic output under a new provincial government.
Consider the significance and scale of the events, the national economic trend has more recently reversed in the back half of the year with a meaningful resurgence in oil and commodity prices. Globally we witnessed a surprising Brexit vote in the UK and the unexpected election of Donald Trump as President in the United States. The threat of terrorism continues to loom over all people as we tragically saw in Paris, Nice, Orlando and on a daily basis in places like Syria and Iraq. All the while stock markets have been flirting with record highs in tandem with increased market volatility.
Underlying all of this is the probability of a rising interest rate environment with the U.S. Federal Reserve leading the charge. Witnessed in the substantial fund flows moving out of debt and back into equity markets it is apparent that investors are reconsidering their current portfolio allocations and how they choose to be positioned moving forward. If you are considering increasing your equity position within your investment portfolio but are concerned about trying to time your entry into equities, then you may want to consider the use of a dollar cost averaging strategy as a means to establish your positions.
Dollar cost averaging is an investment technique used during volatile markets to help reduce the risk of timing a single-sum investment. By investing a fixed dollar amount into the market at regular intervals, the “dollar cost averaging” process helps control the effects of market volatility by smoothing out the average cost per investment unit purchased.
Over time, dollar cost averaging can result in a lower average price and a higher capital gain. Simply put dollar cost averaging involves investing the same amount of money on a regular basis (whether weekly, bi-weekly or monthly) to purchase more shares/units when prices are low and fewer shares/units when prices are high.
When successfully applied, this strategy has the potential to bring down the average cost per share/unit, thereby increasing the chance of achieving higher returns while eliminating the risks of market timing. I also find that the use of a dollar cost averaging strategy has the added benefit of controlling the investor’s emotional reaction to market volatility.
Investors tend to be better able to deal with the stresses that arise from short term dips in the market when implementing a DCA strategy. Over time they actually come to view these dips as opportunities rather than setbacks because they know they are continually buying more units/shares at a lower average cost. Alternatively if the equity markets steadily rise then investors are satisfied with the increasing value of their account holdings overall.
Recognizing the effectiveness of a dollar cost averaging strategy in controlling investor emotions post 2008, many investment firms began and continue to offer their funds with a Dollar Cost Averaging option which is more commonly referred to as a DCA Fund. Although the implementation of the strategy differs slightly between fund companies it generally involves the investor identifying the fund(s) they want to purchase and then using a DCA fund to deploy the contribution over a predetermined frequency of the investor’s choosing.
In the meantime the balance of the original lump sum contribution remains invested in a short term money market fund which invests primarily in short term AAA rated fixed income securities until the capital is ready to be deployed. This strategy can be highly effective for investors looking to make lump sum contributions into the market.
Let’s take a look at dollar cost averaging in action. For example you may have $52,000 that you are looking to invest into a balanced mutual fund. Rather than purchasing $52,000 of units in the balanced mutual fund today you want to dollar cost average into the fund on a systematic basis over the next year.
In this situation your $52,000 contribution would be invested into a money market fund or equivalent on day one and each week thereafter over the next year $1000 would be moved from the money market fund into the balanced mutual fund. This would continue each week for 52 weeks until at the end of the year all $52,000 of your contribution would have been moved into the balanced fund.
I most commonly encounter this situation in the days and weeks leading up to the annual RRSP contribution deadline. By making the bulk of an annual RRSP contribution as one lump sum deposit just prior to the RRSP deadline, the contributor is left susceptible to market volatility and at risk of buying at a market high. By placing the lump sum contribution into a DCA Fund that risk is mitigated and the investor is empowered to take advantage of market volatility by establishing his/her position in smaller increments over time rather than a lump sum investment on a single day.
Some other common examples of situations where investors are looking to make lump sum deposits into the market and may benefit from a DCA fund include;
- Using an RRSP loan strategy to top up a retirement account.
- Recently inherited funds and are looking to deploy them on a non registered basis.
- Sold a business and are looking to invest the proceeds.
- Looking to slowly reposition a portfolio’s current asset allocation.
Even if you aren’t looking to make a lump sum contribution into the market you may already be employing a dollar cost averaging strategy unknowingly without owning a DCA fund. In order to meet savings goals it is quite common to set up a regular contribution schedule into an investment account to fund these goals.
This pre established contribution schedule is indeed a form of dollar cost averaging and is most often established through a systematic contribution plan via payroll deductions at work or on your own with an investment advisor. These deductions are invested as per your instructions into a portfolio of your choosing. Since contributions are made each pay period you are dollar cost averaging into your investments.
If you do not have a group savings program offered through work then you can set up a systematic savings plan with the help of a financial advisor. All Investment firms offer the ability to establish a systematic savings program whereby you choose the contribution amount and frequency and the investment company will do the rest.
Given the increased market volatility over the past several years dollar cost averaging into the market has proven to be a successful investment strategy and one that is very easy to administer and employ. With contribution limits as low as $1000 DCA Funds are gaining great popularity amongst retail investors. Through the use of these funds and a dollar cost averaging strategy investors are beginning to re establish their equity positions in a controlled and systematic way making it possible to benefit from increased market volatility while limiting market timing risk. If you aren’t currently dollar cost averaging into the market then I encourage you to contact either myself or your financial representative to learn more.
Bradley Bumstead is a Vancouver based Financial Planner registered in British Columbia, Alberta and Ontario. Bradley is an Investment Funds Advisor with Investia Financial Services Inc. and Lead Planner at Clear Path Financial Planners which provides integrated personal and corporate planning for high networth families. If you would like to learn more call 604-428-4114 or email firstname.lastname@example.org
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