Dollar Cost Averaging
Posted by Gail | Filed under Investing
When you buy a mutual fund, your money is converted into “units.” Each unit represents a portion of the mutual fund’s total assets. For example, if the current unit value of a mutual fund is $12 and you wish to invest $600, you’d be able to purchase 50 units of the fund. The unit price, referred to as the net asset value per share or NAVPS, generally depends on the current market price of the underlying investments. The NAVPS is calculated by dividing the net asset value of the fund by the number of shares or units held by investors. When the mutual-fund holdings change value, the value of the units also changes.
A lower unit value can work to your advantage if the income generated is being reinvested or if you are taking advantage of dollar-cost averaging by making periodic purchases over the long term. The lower the unit-price, the greater the number of units that can be purchased. Naturally it is always in your interest to “buy low and sell high.” That’s the objective of any investment: to make a profit.
Dollar-cost averaging is a complex name for a simple investment technique. Rather than accumulating a large sum of money before making an investment, you are wiser to invest small amounts at regular intervals.
Let’s say the unit value of a particular mutual fund fluctuated as follows over a 12-month period:
| Unit Value | |
| January | $12.00 |
| February | $13.20 |
| March | $13.40 |
| April | $9.50 |
| May | $9.40 |
| June | $8.60 |
| July | $9.70 |
| August | $10.25 |
| September | $9.35 |
| October | $10.50 |
| November | $12.20 |
| December | $13.00 |
If you saved $80 a month and invested $960 in this fund in December, you would be paying $13 per unit and could therefore buy 73.8 units.
However, if you invested $80 a month, here’s how your acquisitions would look:
| Unit Value | Units Purchased | ||
| January | $12.00 | 6.66 | |
| February | $13.20 | 6.06 | |
| March | $13.40 | 5.97 | |
| April | $9.50 | 8.42 | |
| May | $9.40 | 8.51 | |
| June | $8.60 | 9.30 | |
| July | $9.70 | 8.24 | |
| August | $10.25 | 7.80 | |
| September | $9.35 | 8.55 | |
| October | $10.50 | 7.61 | |
| November | $12.20 | 6.55 | |
| December | $13.00 | 6.15 | |
By using the principles of dollar-cost averaging, you’d be able to buy 89.96 units for an average price of $10.92. So by making purchases at regular intervals, you would have 17 units more than if you made your total purchase in December. At December’s unit price, that’s a return of $221 on an initial investment of $960. Pretty good, isn’t it? The key is this: the average purchase price is less than market average because you buy more units at a lower price.
Dollar-cost averaging means you don’t have to worry about investing at the right time. However, for it to work effectively, you should use it as a long-term strategy — and stick with it! Don’t let market performance shake your trust. It’s a great system.
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May 25, 2010 at 7:13 am
I use a practice similar to this for the ~weekly contributions I make with the excess I skim off our account every Friday after the weeks pay is received and bills are paid. I check the balance on the account I want to contribute to and for the one I’m building up at the moment, there are 3 funds held in the account. I attempt to keep them roughly equal. Each week I contribute to the three in amounts that will bring them back to equal thirds. Whichever one has performed best since the last contribution will get the least funds and the worst performer will get the most. They’ve all taken turns at the top and bottom of the performance order so I think this approach is having the effect you describe.
I know my strengths and weaknesses. If I have to spend too much time studying the long term performance of a fund or stock and try to time my purchases perfectly, I’ll hesitate and start second guessing myself. This system means I get in the habit of making a contribution most weeks (unless I’m making an extra mortgage payment that week), and using a simple way to assess how to divide up the contribution for the week means the task actually gets done.
I stole and adjusted the idea from the Couch Potato investor plan where you contribute to 3 funds equally and once a year rebalance them back to equal thirds by transfering between the funds. I find this has the same effect but gets the money in faster and takes advantage of a poor week buy loading up on that fund.
May 25, 2010 at 8:08 am
We are going to be starting monthly contributions to our RRSPs and we will be able to take advantage of Dollar cost averaging.
regards,
Jason
May 25, 2010 at 9:45 am
Thanks for this clear explanation and example Gail. My financial advisor explained this concept to me when we set up monthly contributions to RRSPs, and though I think I got the basic idea from his spiel, this was certainly a better explanation than he gave me!
May 25, 2010 at 12:17 pm
The main benefit of dollar-cost averaging is that it smooths out the average purchase price. This reduces risk. The idea that it causes you to get more units for your money over a lump-sum purchase is just a myth. If the $80 per month were saved up and used in June and then saved up and used in December, the number of units would be 92.7. Dollar-cost averaging is a good idea, but not for the reasons usually given.
May 25, 2010 at 12:42 pm
For me, I do DCA simply because I’m lazy. It’s just easier to setup the withdrawal on the same days I get paid. It’s a fire and forget it type of approach. I just don’t know if I’d invest if I saved up and did it lump sums. It’s also easier to stomach losing $150 if I invest it today versus $15,000 if I saved it up over the year, you know?
May 25, 2010 at 1:00 pm
Gail and Michael James, you’ve both made mistakes, Gail on math, and Michael James on theory:
The advantage of DCA comes down to the difference between the harmonic mean and arithmetic mean. This is fundamental mathematics (not just some theory) and the harmonic mean will always be less than the arithmetic mean.
In the article, you say your “average” price is $10.92/unit, which is the average of the monthly unit value (arithmetic mean). Your book value is actually lower, at $10.67/unit, $960/89.96 units (harmonic mean). You want to DCA by purchasing using the same amount of money each time.
If you want to DCA while selling, you want to sell the same number of UNITS each time, since the arithmetic mean is always larger!
In this example, someone who had 89.96 units in January and sold 1/12 of 89.96 each month would net an average of $10.92/unit ($982.36), while the person buying $80 each month would only spend $960! Of course, waiting and selling all your units at $13.40 in March gets you the largest return, but this involves market timeing and a crystal ball.
May 25, 2010 at 1:34 pm
Raiden: I understand the difference between arithmetic and harmonic means. However, the arithmetic mean is not relevant here. If a lump sum were spent in a random month in the year, the expected number of units purchased would be the average of (lump sum)/(month’s price) for each month. The harmonic mean is relevant to both the lump sum case and the periodic investment case. The advantage of periodic investing is that you tend to get a more smoothed-out price (less volatility).
The arithmetic mean is relevant only when you buy a fixed number of units each month. But who gets paid a variable amount based on the price of some unrelated fund?
All the talk of slight gains due to differences in types of means is a nice parlour trick, but the real advantage of periodic investing is psychological. It forces you to invest now rather than to put it off to some time when you think you’ll magically have some lump sum of money available.
May 25, 2010 at 3:17 pm
I’m with Geoff. It’s a good thing that it’s a good idea AND easy, because I am lazy too. Our $200/month comes out of the chequing account automatically at $100 every 2 weeks. It’s invested in some moderate risk funds that fluctuate “moderately” some months its low, other months better, and they keep telling us that in the LONG RUN we’ll be ahead. Since we are still at leat 25 years from even considering retirement, the DCA should work in our favour with minimal effort on our part (since it’s automatic). I know if we tried to save up that amount every month and put it on a lump investment at the end of the year we’d never do it!
May 25, 2010 at 3:40 pm
Intuitively, without mathematically analysing this, it makes sense to me because if I try to time the market (aka purchase with lump sum) then my chances of doing good are 50%, however if I invest regularly, then I will be hit by both highs and lows on lesser amounts therefore have a less volatile investment experience.
May 25, 2010 at 3:44 pm
@ Jason – if you get paid bi-weekly or weekly you should implement the dollar cost average strategy in coordination with your pay. The more frequent that you buy the better off you’ll be in the long-run.
May 25, 2010 at 3:54 pm
In my opinion, DCA is an often underrated advantage of low cost index funds over ETFs and individual stocks. Since trading fees make buying ETFs/individual stocks more often than a couple times a year cost prohibitive, market timing has a much more significant impact on your puchases.
By contributing regularly to mutual funds (I do biweekly on the day I get paid), you greatly reduce the effect of market timing and your need for a crystal ball.
May 25, 2010 at 8:30 pm
Just a thought on automatic withdrawals timed to coincide with payday. Perhaps having in come out a day or even two after each payday is safer. If there is any problem with the automatic pay deposit and you don’t keep a buffer in your account, you may have an overdraft problem if the contribution goes out before the pay arrives.
May 26, 2010 at 5:02 am
This I understand, but what should a girl with a VERY erratic salary disbursement to do. Okay, I’m self employed and 3-9 months of the year, the bills eat everything up, but then there are months where I find I can have $5000 – $10000 to put aside for my RRSP’s and mortgage topup. How do I handle this to get the most bank for my buck?
June 1, 2010 at 6:04 am
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