“Markets have been volatile…Is now the right time to invest? Do I have enough money set aside to make an RRSP contribution before the deadline?”
When the RRSP deadline approaches, these are common questions that many Canadians are asking themselves in the months of January and February each year. They can sometimes lead you to experience undue stress both financially and psychologically. But what if you could do something to make both of these questions irrelevant?
Starting a dollar-cost averaging strategy by setting up automatic pre-authorized contributions directly from your chequing account into your RRSP can solve both of these dilemmas. And it’s easier than you think.
How does it work?
The concept is simple. Set up automatic withdrawals from your chequing account on a regular basis that are sent directly to your RRSP and immediately invested. This can be set up as a weekly, bi-weekly, or monthly contribution to ensure you are always saving. The more you can save each period the better but you can start doing this at as low as $25 per contribution. The institution where you have your chequing account does not need to be the one where the RRSP contribution is sent and every financial institution in the country can facilitate this. It is usually just a matter of signing off on a form or two.
What is Dollar-Cost Averaging?
Dollar-cost averaging is a very simple yet effective strategy that involves investing a fixed-dollar amount on regular intervals as described above. Investing a fixed-dollar amount allows you to buy more units of the investment when prices fall and fewer units are bought when prices rise. This can result in lowering your average unit cost over time which reduces the concern of buying high or poor market timing. You need not concern yourself with whether now is the right time to invest as you will always be investing. It ensures you never miss out on market gains or recoveries by always being invested. I’ve provided three examples below to help illustrate how this works and the potential benefit over the long term.
Figure 1:
| Lump Sum | Dollar-Cost Averaging | |||||||||||||
| # of Units Purchased | # of Units Purchased | |||||||||||||
| Unit
Price |
Jan | Feb | Mar | Apr | May | Jun | Unit
Price |
Jan | Feb | Mar | Apr | May | Jun | |
| $ 8 | 0 | $ 8 | 13 | |||||||||||
| $ 9 | 0 | 0 | 0 | $ 9 | 11 | 11 | 11 | |||||||
| $10 | 60 | $10 | 10 | |||||||||||
| $11 | 0 | $11 | 9 | |||||||||||
| $12 | $12 | |||||||||||||
In Figure 1 above, you can see the dollar-cost averaging approach in comparison with a lump sum purchase of an investment. Rather than making a single lump-sum investment in January, the investor contributes $100 each month into the same investment at the current price of the investment on that date. Over the 6 month period the investment price fluctuates from $10 down to $8 and eventually rises back up to $11. The investor’s $100 buys more units when the investment price has dropped, like in March, and fewer units in June when it is higher. In total, they invested $600 and were able to purchase 65 units. This works out to an average price of $9.23 per unit. If they had invested the entire $600 in January they would have only purchased 60 units with an average price of $10 per unit. In this example, if the investor cashed out the investment at the end of June they would have actually achieved a better return as a result of the investment dropping in value over certain periods than they would have if they invested as a lump-sum.
| Strategy | Initial Unit Price | Total Amount Invested | Total Units Acquired | Average Cost Per Unit | June Closing Value |
| Lump Sum | $10.00 | $600 | 60 | $10.00 | $660 |
| Dollar-Cost Averaging | $10.00 | $600 | 65 | $9.23 | $715 |
It is important to note that if the investment had gone straight up that the average cost per unit on the dollar-cost averaging strategy would be higher and the return in the end would be lower than the lump-sum approach. However, since we have no way to predict the fluctuations the dollar-cost averaging approach will always reduce the possibility of buying high and selling low. We will explore this in the second example below.
Figure 2:
| Lump Sum | Dollar-Cost Averaging | |||||||||||||
| # of Units Purchased | # of Units Purchased | |||||||||||||
| Unit
Price |
Jan | Feb | Mar | Apr | May | Jun | Unit
Price |
Jan | Feb | Mar | Apr | May | Jun | |
| $ 8 | 0 | 0 | $ 8 | 13 | 13 | |||||||||
| $ 9 | 0 | 0 | $ 9 | 11 | 11 | |||||||||
| $10 | 60 | $10 | 10 | |||||||||||
| $11 | 0 | $11 | 9 | |||||||||||
| $12 | $12 | |||||||||||||
In this similar example, the investment price rose to a high of $11 in February, reached a low of $8 in April and finished below the initial investment price in June closing at $9. This is an example where the dollar-cost averaging investor wound up buying higher at certain periods and sold at a lower price than their initial purchase in the end.
| Strategy | Initial Unit Price | Total Amount Invested | Total Units Acquired | Average Cost Per Unit | June Closing Value |
| Lump-sum | $10.00 | $600 | 60 | $10.00 | $540 |
| Dollar-Cost Averaging | $10.00 | $600 | 67 | $8.96 | $603 |
As you can see, despite buying an identical investment the two approaches produced markedly different results. Since the investment was down at the end of the period the lump-sum approach resulted in a loss. Meanwhile the dollar-cost averaging approach resulted in a modest gain due to acquiring additional shares while the investment price was lower.
In our final example we will compare real investment results using actual historical market data from one of the most challenging 10-year periods to invest, January 31 2008 – January 31, 2018. The graphs below show the results if you had bought the S&P/TSX Composite Index as a $12,000 lump sum at the beginning of the 10 years versus someone investing $100 at the end of each month over the 10 year period.
Data source: Morningstar.ca
Data source: Morningstar.ca
As you can see, the results are actually quite similar in the end. The lump sum investor finishes with $14,551 at the end of the 10-year period while the dollar-cost averaging investor finishes marginally ahead at $14,832. The difference between the two strategies is the experience of the investor. The lump sum investor is in negative territory approximately 47% of the time while the dollar-cost averaging investor is only in negative territory 16% of the time. Again, if the investment had simply gone straight up the dollar-cost averaging would not have benefitted the investor since they would have been buying at higher and higher prices. However, we cannot predict what types of fluctuations the investment will experience and they do not go up in straight lines.
Setting up pre-authorized contributions on a periodic basis (bi-weekly, monthly, etc.) will ensure a disciplined approach to saving that will prevent you from having to scramble to come up with some cash at the RRSP deadline. It will make it easier for you to save and result in less short-term pain in terms of budgeting and spending by avoiding the spending crunch required for you to save up a decent sum of money in a short period of time. It should also reduce any concerns you have about stock market volatility and prevent you from attempting to time the market. It keeps you invested over the long term and reduces the potential for emotional investing decisions.
Make your life simpler and more worry-free by setting up automatic pre-authorized contributions to your RRSP (or TFSA) today.