indicatorInvesting and Saving

What is dollar cost averaging and what are the benefits?

By ATB Investment Management Inc. 30 April 2020 6 min read

 

What does dollar cost averaging mean?

Dollar cost averaging (DCA) is just a fancy way of saying investing continuously over time. It could mean that you have a regular (or pre-authorized) contribution set up to go from your bank account to investment account every month or on another predetermined schedule. Or, it could mean that whenever you get a lump sum of money, you invest it based on a schedule over several months as opposed to all at once. In both cases, you are averaging your money into the stock market and buying at various prices, not because you are market-timing, but rather basing it on your established schedule.

Some days, the markets may be higher than usual and some days they may be lower. A DCA schedule also rebalances your portfolio as you are investing based on the valuations at that time, so more money will be allocated to positions that have done poorly based on your asset mix (split between bonds and equities). Over time, this process helps average your investment cost. It can also have some additional benefits when we are in periods of volatility and prices are low.

 

How can dollar cost averaging help an investor?

Dollar cost averaging can help an investor in two main ways:

  • First, the process of creating a systematic approach to investing can create healthy habits as it almost forces an investor to pay themselves first. Automatic contributions to an investment account take the guesswork out of investing and likely lead to increased investment contributions over time.
  • Second, using a DCA strategy helps an investor take advantage of all market conditions. The automatic contributions would typically continue if markets were hitting new highs or new lows and over time, this helps to average investment costs (or book value). Without a DCA strategy, an investor could potentially sit on cash waiting for the “perfect” time to enter the stock market.

 

Does DCA have an impact on rebounding after a bear market?

Intuitively, we can assume that a DCA strategy will help a portfolio’s ability to rebound following a bear market because we are continuing to add money to our portfolio despite markets being down in excess of 20%.

Assuming that our portfolio has a target asset mix (split between bonds and equities), investing in a down market would likely mean most of our cash would be allocated to the hardest hit investments, which is typically equities during a bear market. This means that we are buying low-priced equities to balance our asset mix during bear markets, and buying bonds during market upswings when equities are more expensive. This process is effectively a rebalancing strategy.

Investor rebalancing helps to prevent portfolio drift, which can cause an increase in the risk profile of an investment portfolio. Portfolio drift is when the asset mix of the portfolio drifts with the current stock market conditions. Meaning, when equities are increasing in value, without rebalancing, an investor's portfolio will drift towards having a much higher allocation to equities than the investor originally had intended.

 

Lets see some numbers

Using the 2008 financial crisis as an example of what to expect from rebalancing into equities during market volatility, we can see that the rebalancing can actually exacerbate the drawdown when looking at a short time-frame.

In the below chart, we start both the rebalancing portfolio and the non-rebalancing portfolio with an asset mix of a 60% equity weight and a 40% fixed income weight at the end of 2007. The rebalancing portfolio that buys equity throughout ends up losing about 4% more by the time the stock market bottom arrives during March of 2009. By March 2009, the non-rebalancing portfolio had dropped to an equity weight of just over 40% which helped the portfolio outperform. The rebalancing portfolio does gain quicker from that point on, but it needs to make up the extra 4% loss.

As it turns out, both fully recover to Dec 2007 values at about the same time during October of 2010. Over time, we can see that the rebalancing portfolio does end up with a slightly higher value.

 

Rebalancing compared to no rebalancing growth of $100
with a target 60% equity 40% bond*

*Equities represented by the S&P 500 and bonds represented by aggregate US Universe bonds.
Source: Bloomberg


 

If rebalancing or a dollar cost averaging strategy doesn’t save us during a bear market, why do it at all?

Rebalancing involves reducing equities during good times too, not just adding equities during the bad times. This is because when equities are performing well, adding new money through a DCA strategy would involve purchasing bonds which would have drifted below their target.

If we look over a longer time frame, from the end of 1989 to 2019, rebalancing keeps equity weights from drifting off their target during periods of strong equity performance. When a bear market does occur, the rebalanced portfolio performs better on the downside than the portfolio left unchecked over this longer observation period. This is due to equity weights not deviating from the 60% target, whereas the portfolio that doesn’t rebalance ends up with equities increasing to 80% or more around 2000, 75% in mid 2007, and back up to 82% by Feb 2019. The increased weight in equities from portfolio drift adds additional volatility to the portfolio and can hurt performance as equities tend to be impacted most during volatility markets.

 

Rebalancing compared to no rebalancing growth of $100
with a target 60% equity 40% bond*

*Equities represented by the S&P 500 and bonds represented by aggregate US Universe bonds.
Source: Bloomberg


 

So while rebalancing doesn’t appear to help if looking strictly from the start of the bear market, it does help to keep the portfolio on target over longer periods. This keeps the risk profile of the investment portfolio aligned with the investors expectations and can help create a more expected range of outcomes during market volatility.

When a bear market (stock market declines of 20% or more) does come, the disciplined approach from rebalancing ends up blunting the decline the portfolio experiences relative to a portfolio that would have just been left to drift/float off the desired asset mix.

The benefits we see through rebalancing or having a DCA strategy in place on the chart above:

  • During 2000 to 2003, the DCA portfolio lost 22% of its value vs 30% for the floating portfolio.
  • During 2007 to 2009, the DCA portfolio lost 35% of its value vs 39% for the floating portfolio.
  • During the most recent Covid downturn, the DCA portfolio lost 22% of its value vs 28% for the floating portfolio.

At the end of the day, you can run a number of different rebalancing strategies, or choose not to rebalance. The results will always be time frame dependent, just as we saw on the above two charts comparing a narrow period versus a longer period. As shown, over the full 30 years, the portfolio that rebalances smooths out the bumps a little, but both are virtually tied at the end. As an investor, we know that the smoother ride provides comfort and often allows investors to stay invested during the periods of market volatility.

 

How does Compass benefit investors?

One of the main benefits of the Compass Portfolios has been our consistent approach over the last 15+ years. Compass systematically rebalances the portfolios to keep the asset mix on target, allowing the portfolios to be in line with an individual's risk tolerance. If we did not take this disciplined approach, a conservative investor may end up with too much risk through an increased equity weight following strong market performance. We focus on taking advantage of market conditions and buying bonds and equities when they have low valuations.

We believe that consistency is key to our investors success as we want to help provide a smooth investment journey. Contact us for help with your investment journey.

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