About 20 years ago, I arranged for a monthly deduction to be made from my bank account and for that money to be invested in a portfolio of mutual funds as part of a registered retirement savings plan (RRSP).
As a result, I have never rushed to make a contribution before the RRSP deadline. I have invested a predetermined amount every month since 1997. Over time, my salary has risen and so I’ve increased that monthly contribution accordingly. I can say without reservation that I’ve saved more as a result of this approach.
This isn’t just about saving, though. What I’m describing is referred to as dollar-cost averaging. Its real power lies in the fact that I’ve invested the same dollar amount each month. So when the value of the mutual funds in my portfolio was up – as it was during the technology bubble in 1999 – my money bought fewer fund units. When their value was lower – think 2009 – I bought more.
It’s a deceptively simple idea. By committing to a dollar figure, and to regular saving, I have ignored market volatility. I’ve never timed the market. The truth is I really don’t think about it that much.
Does dollar-cost averaging really work?
After writing about this a couple of years ago, a financial advisor challenged me on the wisdom of dollar-cost averaging. To be fair, there has been research done that questions the strategy.
One study put it this way: If you inherited $1 million, would you be better off investing it all at once or would your portfolio perform better if you were to invest the funds gradually over time (in other words, if you implemented a dollar-cost averaging strategy)?
Researchers studied stock and bond returns in the U.S., U.K. and Australia. The study covered multiple stretches of time that featured widely varying market conditions, and investment holding periods ranging from one to 30 years. About 2/3 of the time, investors were better off with a lump-sum approach than they were a dollar-cost averaging strategy.
Does that mean dollar-cost averaging is a mistake?
Maybe, if you come into a large sum of money all at once, and you have a long enough time horizon before you need your money. This argument against dollar-cost averaging isn't complicated. It merely (and correctly) identifies the likelihood that over time, your money will perform better if it is invested in the markets than it will if it is held in cash (either in a savings account or a low-interest earning cash instrument like a guaranteed investment certificate). If someone hands you $1 million, it's probably not in your best interest to invest $100,000 into a balanced portfolio and stuff the rest under your mattress to be invested a little at a time.
But for those of us not lucky enough to inherit a small fortune, dollar-cost averaging still makes sense. It helps make saving easier, and it prevents our trying to time the market. Dollar-cost averaging is as much a saving strategy as it is an investment strategy.