Say you have money to invest – perhaps into your registered retirement savings plan (RRSP) or tax-free savings account (TFSA) – but you're afraid the markets might take a dive after you've added to your nest egg.
To avoid this risk, many investors opt for dollar-cost averaging, spreading their investments out over a period of time rather than taking the plunge all at once. Investing a set amount each month, for instance, or according to a formula based on fluctuations in the market, can allow you to hedge against – and even take advantage of – the sudden lows that inevitably come along.
The practice is common in employer-based RRSPs, defined-contribution pension plans and other systematic savings and investment programs.
To some investors, dollar-cost averaging, or DCA, adds an element of diversification to a portfolio and helps to manage risk.
"You have to have a game plan," says Carien Jutting, a certified financial planner and president of Fiscal Wellness Inc. in Stratford, Ont., who appreciates the peace of mind with DCA. "It gives 'sleep factor.'"
Investors must first consider the purpose of the investment, when and for what the money is required, as well as lifestyle needs in retirement, Ms. Jutting says.
Clients with a lump sum to invest in the market should consider putting part of it into a GIC ladder, "something relatively safe and boring," with the amounts coming due at regular intervals and then reinvested when they mature. "You're going to enter the market at different periods of time."
Not every expert is a fan of dollar-cost averaging, however. Sandi Martin, a fee-for-service financial planner at Spring Personal Finance in Gravenhurst, Ont., says that lump-sum investing is simpler and offers better returns than DCA, so it makes more sense as long as investors have the right asset mix.
She notes that in a 2016 study by Vanguard Group of markets in the United States, Britain and Australia, immediate investment outperformed DCA two-thirds of the time, by a range of 1.45 per to 2.39 per cent. The study noted that "investing immediately has historically provided better portfolio returns on average than temporarily holding cash."
However, while lump-sum investing comes out ahead on average, there is always risk. A 2012 Vanguard simulation noted that in the worst 5 per cent of results in the U.S., an investor who went all-in with $1-million ended up with $200,000 less after 10 years, compared with DCA.
Also, investing all at once is easier to execute, Ms. Martin says.
"Investing over 12 months means that you have 11 extra items on a likely already crowded to-do list, 11 extra opportunities for short-term market valuations and punditry to tempt you into trying something clever, and 11 extra periods of time when your asset allocation is harder to manage."
Investors who follow DCA might be swayed by emotion or by advisers with overly complex formulas to follow. Regret and risk-minimization are the main reasons people practice DCA, Ms. Martin says.
"Investors are afraid that they'll invest at exactly the wrong time, and advisers are afraid that they'll get blamed if markets go down," she says.
"If you have the risk tolerance to invest in a particular asset allocation and can already accept the volatility and expected returns that come with it, monkeying around with DCA-ing into that allocation is a bad idea," she says. "If you can't stomach the idea that your investment will go down the day after you invest it, you don't have the right asset mix in the first place."
Gradual investments are reasonable if you're willing to accept the likelihood of lower returns, says Jim Yih, an Edmonton financial educator, fee-only planner and blogger at RetireHappy.ca. He says that DCA is a good tradeoff for those nervous about the natural ups and downs of the market.
"DCA is a risk-management strategy, it's not a return-enhancing strategy," he says. "It's good for the heart."
Mr. Yih stresses that it's important to stick to a strict timetable, investing equal amounts each month or each quarter. "It takes all the guesswork out of it," he says. "The more you do automatically, the better you are."
Investors can also use formulas for gradual investing, so-called "smart" DCA, by buying into the market whenever a benchmark stock index declines more than a certain amount.
These strategies give investors a gauge to help them buy low. They may beat traditional DCA, but Mr. Yih does not subscribe to them because they force investors to buy at the scariest moments for stocks. "People aren't wired that way," he says.
Do-it-yourselfers can follow DCA but need knowledge, confidence and stick-to-it-iveness. "Emotions can get us into trouble and make us do the wrong thing at the wrong time," he says. "At the end of the day the markets are random, they don't follow patterns."
Ms. Jutting says that "most people are quite risk-averse," and although DCA doesn't always seem to make sense "when the numbers are good," it's important to follow the formula. "DCA must be systematic."
It's especially important to avoid guesswork and trying to time the market. "The chances of being right are slim to none. In-vesting is not about making quick bucks – that's just gambling."
Ms. Jutting cautions that "there is no guarantee" with any investment philosophy, but DCA is a common way to temper risk.
"How do you eat an elephant? One bite at a time," she says. "That's what dollar-cost averaging is."