Dollar Cost Averaging and How You Can Use it to Mitigate Risk

When you invest, it is important that you have a plan on how you are going to build your portfolio. A good tool to include in your plan is a concept called dollar cost averaging.

Having a plan is important because it helps you bring discipline to your investing. Disciplined investing helps avoid emotional decision based on market fluctuations. Keeping your faith in a long term plan can save your portfolio from impulsive decisions in a bear market. A common long term plan that works for the lifestyle of many investors is dollar cost averaging.

Dollar cost averaging is when an investor contributes a set amount to their portfolio on a predetermined basis. Dollar cost averaging is great because it is impervious to emotionally driven speculation. Dollar cost averaging will naturally buy more of a stock when the price falls and less of a stock when the price is high, following the age old mantra of “buy low and sell high”.

The Benefits of Dollar Cost Averaging

One of the benefits of dollar cost averaging is that over time your average cost per share will decrease. It also serves as a great way to protect yourself from risk because it lets investors avoid investing a large amount of money in an asset at the wrong time. It also takes a lot of the stress and difficult decision-making out of the investing process because you don’t have to worry about when or how much you are going to invest.

Another good thing about dollar cost averaging is it helps you to build good investing habits. It is a good idea to regularly contribute a portion of your paycheques to investing. A dollar-cost-average strategy is a good way to get used to doing this without having to worry about what you are going to put your money into each month.

Now let’s look at an example:

If I buy $100 of ETF XYZ let’s look at a breakdown over 6 months:

Month 1: Price=$4 so we buy 25 shares

Month 2: Price=$5 so we are able to buy 20 shares

Month 3: Price=$3 so we are able to buy 33 shares

Month 4: Price=$4 so we are able to buy 25 shares

Month 5: Price=$6 so we are able to buy 16 shares

Month 6: Price=$5 so we are able to buy 20 shares

At the end of the six months we have 139 total shares of XYZ at an average price of $4.32. It is impressive that our average is this low because the share price was at or above 4$ for five of the six months. This is the power of dollar cost averaging. If we sold at 5$ per share we would have a 16% ($95) profit.

Dollar cost averaging is a technique best used with ETFs. Especially if you are using a brokerage like Questrade that offers free ETF purchases. Personally, I take a DCA approach by putting aside a portion of every paycheque and making a small contribution to the ETFs I hold in my TFSA.

The Drawbacks of Dollar Cost Averaging

Dollar cost averaging does a great job of minimizing your risk. However, it can also minimize your chances of putting a large sum of money in at the right time. As a result, your profits usually won’t be as high as someone who employs a more active approach.

Imagine you are dollar cost averaging an ETF. You are averaging the price as the price goes up or down. Therefore, if the price is climbing, you are minimizing returns with each purchase. If you’re wondering why you should keep purchasing then, as prices climb, then consider this. The more money you put into an investment, the greater the total sum will be when it is time to sell. This is important to consider when taking dollar cost averaging drawbacks into account.

However, the minimal management necessary to employ a dollar cost averaging strategy can make it a great fit for many investors. This is particularly true if you use it with ETFs, as we recommend. This is a low-risk and low-commitment type of investing that doesn’t require nearly as much research and time.

The lowered risk, minimal stress, and small low management of dollar cost averaging can make it a good strategy for many DIY investors. It reinforces the good investing habit of regularly contributing to your portfolio, and helps avoid impulsive decisions when the market is in a recession. Because of this, we highly recommend dollar cost averaging as a tool you can use in your own portfolio.

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