Question: I understand the benefit of dollar-cost averaging into stocks, but does it also make sense when buying bonds?
Answer: Dollar-cost averaging -- the practice of purchasing securities at fixed intervals and in equal amounts over time rather than in one lump sum -- has long been used as a way to avoid jumping into the market at the wrong time.
To illustrate how dollar-cost averaging, or DCA, works, consider an investor wishing to buy $10,000 worth of units of a mutual fund. He could use the lump-sum approach and buy all the shares at once. However, there would be a risk -- especially in a high-flying market -- that the market could turn negative shortly thereafter, resulting in an immediate loss on his new investment. Rather than try to determine when the time is right to buy, the investor could ease into the position, for instance by purchasing $1,000 worth every month for 10 months. That way, if the fund loses value during that period, less of the investment is exposed to this loss and the investor ends up buying some of the new shares at a lower price than he would have with the lump-sum approach. Of course, if the fund's shares continue to rise, dollar-cost averaging would impose an opportunity cost compared with the lump-sum approach, which, in hindsight, would have produced better results. But, of course, none of us invests in hindsight.
Smoothing out the bumps
One of the primary benefits of DCA is that it reduces volatility when buying securities. Rather than risk a purchase price that's too high, DCA allows the investor to buy more units when prices are low and fewer when they are high during a given time period. It also offers investors a straightforward investing system that avoids the challenge of market-timing. Even though DCA might not always result in the highest long-term performance -- historically lump-sum investing in stocks tends to outperform DCA approaches, as discussed in this Ask The Expert article -- it is a sound strategy for investors jittery about where the market is headed.
DCA is most often mentioned with regard to stock-related purchases, probably because equity markets tend to be far more volatile than bond markets. However, there's no reason why you can't use the approach when buying bonds or bond funds, as well. In fact, given the uncertainty regarding interest rates, this might be as good a time as any to use DCA when buying new bonds or bond funds, or if rebalancing your retirement portfolio, to add to your fixed-income holdings.
Not your typical rebalancing environment
Coming off the stock market's strong performance since the financial crisis -- with the S&P/TSX Composite Index returning around 11% annually on average during the past five years -- many investors may find their retirement accounts out of balance, with oversized allocations to stocks. In a typical market environment the conventional wisdom would be to rebalance by shifting a portion of assets from stocks to bonds. That way, if stocks experience a correction, those recent gains are protected by shifting money into a less volatile asset class with a low correlation to stocks. However, these days bonds aren't quite the safe haven they've been in the past. That's because when interest rates do rise -- whenever that may be -- the value of existing bonds will likely drop.
With stocks appearing to be at least slightly overpriced and bonds facing very real interest-rate risk, you might wonder whether dollar-cost averaging from one to the other still makes sense. The answer is a qualified yes, but with an added step that may help lower risk. One idea is to sell some of your stock holdings and keep the money in a cash account, such as a money market, before dollar-cost averaging into bonds. (You could even dollar-cost average out of stocks if you wanted, though this would mean exposing the assets to be rebalanced to the possibility of stock losses for a longer period of time.) By putting the money into cash first, you reduce your equity exposure in case a market downturn should materialize, and you limit exposure to interest-rate risk by not putting assets all into bonds right away. Instead you can ease into bonds slowly, so if rates do start to rise and bonds lose value, you'll avoid some of those losses while buying more bonds than you would have if you had jumped in with a lump sum. Morningstar's Christine Benz offers additional advice for rebalancing into bonds in this article.
No free lunch here
It's important to point out that this DCA approach using a cash account as an intermediate step is not truly risk-free. For one, holding money in cash these days often means getting a return of less than 1%, which might be tough for some investors to stomach if stocks or bonds continue to make gains. Also, there's no guarantee that stocks or bonds will go down during the time period in which you are dollar-cost averaging. After interest rates rose during the second half of 2013, it seemed like a safe bet that they would continue to do so in 2014. But instead the opposite has happened; rates have eased, with the 10-year Government of Canada bond falling from around 2.8% at the start of 2014 to around 2.6% as of the second week of July. That means if you had begun buying bonds using DCA at the start of this year you'd likely be worse off than if you'd used the lump-sum method, at least in the near term.
Given the unpredictable nature of the markets, it's easy to see why DCA appeals to many investors. It can help reduce volatility and the odds of buyer's remorse should you invest a lump sum at what turns out to be exactly the wrong time.
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