In late October many news stories surfaced sounding the alarm bells that Canadians are now working longer than they did in the 1990’s. There are many factors that contribute to this trend including the move from Defined Pension Plans to Defined Contribution Plans, the removal of indexing of existing pensions, higher levels of debt and a reduction or even suspension of RRSP contributions during down markets.
Contributing to your RRSP in bad times can be painful and may not make you feel good but over time, it works. My message this month is not new but is timely. Given recent declines in investment markets since this part April, perhaps it is time to give Dollar Cost Averaging a second look.
Using Dollar Cost Averaging In a Fluctuating Market
The chart below provides an example of dollar cost averaging. Starting in January, an investor begins by investing $100 each month in a fund. In January, the fund is selling for $10 per unit, so a $100 investment buys 10 units. In February, the fund’s price increases to $11 per unit, so $100 now buys 9.1 units. In March the price drops to $6 per unit, and so the $100 investment buys 16.7 units. So, by the end of March, $300 has been invested, 35.8 units have been purchased, and the investment is now worth $214.80 (35.8 units times $6 per unit). It doesn’t feel so good does it? Over the course of the next several months, the market begins to rise once again. As you can see, at the end of five months, the fund’s unit price has risen from a low of $6 in March to $9 in May. Even though the unit price is still 11% below its $10 starting point in January dollar cost averaging has paid off. The $500, invested in $100 increments each month, has purchased 59.4 units, which are now worth $534.60. Now consider what may have happened if dollar cost averaging had not been used. Suppose that same $500 had been invested all in one lump-sum back in January, when the fund was valued at $10 per unit. Only 50 units would have been purchased, meaning that by May, with the fund valued at $9 per unit, the total market value in the account would be worth only $450.
Your average cost per unit is $8.41.
|
Month |
Monthly Amount |
Unit Price |
# Units Purchased |
Market Value |
|
January |
$100.00 |
$10.00 |
10 |
$100.00 |
|
February |
$100.00 |
$11.00 |
9.1 |
$210.10 |
|
March |
$100.00 |
$6.00 |
16.7 |
$214.80 |
|
April |
$100.00 |
$8.00 |
12.5 |
$386.40 |
|
May |
$100.00 |
$9.00 |
11.1 |
$534.60 |
We don’t know if markets will return to positive result for 5 months, 10 months or beyond but it is our opinion that once a market does recover, those clients who have adopted a Dollar Cost Average strategy are more likely to recover faster and have greater returns over the long run.
A good investor many times is willing to do what most investors are not willing to do. When markets are down they systematically contribute to their account and take advantage of buying more units at a lower cost and being well positioned with a higher number of units when the market rebounds.
This strategy works best when you are adding to an existing account.