Using dollar-cost averaging to help mitigate risk

So you’ve earmarked some money to invest, but you’re now concerned that markets may be headed for a bumpy ride? To help alleviate some of your concerns, you may want to consider using a strategy known as dollar-cost averaging (DCA), which could help take advantage of market dips. This strategy involves investing smaller amounts over a longer period of time. You invest a pre-determined amount on a set schedule—say, every month or every quarter— regardless of the security price.

Why choose dollar-cost averaging (DCA)?

The rationale behind DCA is that you will naturally purchase more shares when prices are lower and fewer shares when prices are higher. If the markets dip, you’ll be investing when securities are more attractively priced. If markets rise, you space out your purchase price over time so that you’re not necessarily investing all your money when prices are at their peak.

How it works in practice

As an example, let’s say you want to invest $10,000 in a particular stock, but you’re worried about short-term market volatility. So, you decide to dollar-cost average into that investment. You break up the total into five equal portions of $2,000, which you will invest on the same day over each of the next five months, regardless of the price on that day. There are many scenarios that could play out, but let’s imagine one where the price of the stock drops but begins to rebound.

Note: This is a simplified example that does not include trading fees

As the table shows, in this scenario, DCA was a winning strategy. At the end of the five-month period, the market value of your position is 28 percent higher than the amount you invested. This is despite the fact that the stock price at the beginning of May is 20 percent lower than when you started buying it in January.

Benefits of a DCA approach

A gradual investment approach can be favourable in volatile markets, or when a bull market is running out of steam. Consider the scenario above: if you invested the whole $10,000 on January 1 when the stock price was $50, your 200 shares would be worth $8,000 on May 1, an unrealized loss of $2,000. Compare that to the gain of $2,800 when the money is invested gradually.

Another advantage of DCA is that it removes the guesswork and worry of choosing the best time to enter the market. Ideally, you always want to “buy low,” but the inherent unpredictability of markets makes it impossible to know for sure if your timing is right. A DCA strategy can help you solve the dilemma of timing the market. By making regular investments over time, you base your returns on the overall trend as opposed to the specific entry price.

Potential downsides of DCA

When markets are steadily rising, a DCA strategy will not produce the best outcome. In a market rally, you’re better off getting in early with a lump-sum investment, and gaining exposure to the upward trend right away. However, timing is pivotal in the case of lump-sum investing. You wouldn’t want to invest a lump sum just before a prolonged market decline.

Overall, your outlook for the markets and your risk appetite will determine what strategy is a good fit for you. If you’re concerned about the potential for a downturn, market correction or prolonged period of volatility, DCA can be an effective way to mitigate risk. If you expect markets to rise, you might prefer to invest a larger sum, sooner.

A final word: if you have a long time-horizon, you should also ask yourself how appropriate it is to worry about short-term market volatility. Generally, the more time you expect to remain invested, the less important your entry point becomes. Over long timeframes, say ten years or more, your investment has lots of time to recover from any near-term drop.

There are several ways to approach DCA

Setting up automatic contributions is a great way to start a DCA investing strategy.  To set up recurring or one-off contributions and set a date to place a trade each month. To set up recurring contributions, log in to your Qtrade Investor account and go to My Accounts > Transfer funds > Electronic Funds Transfer. Complete the transfer form and select how often you want to make the contribution in the Frequency dropdown.

You can also set up a systematic plan to regularly invest into a mutual fund. To set up a systematic plan to invest regularly into mutual funds using this instruction form.