Question. Hi, I read recently that the TFSA limit has been increased this year, and I want to make sure I’m maximizing my contributions. I find it’s often quite stressful to come up with the money for contribution. This year, with the higher limit, I just know I’m going to have a hard time again, and I’d like to be a bit more proactive. How can I get on track? Do you have any advice or suggestions for me?
Answer. Great question. First of all, yes, you are correct – the TFSA limit for 2019 has been increased to $6,000. For more information on that, please see our recent blog post, New TFSA Limit.
Indeed, many investors have good intentions of maximizing TFSA contributions, and then find themselves scrambling, last minute, to come up with the funds. The reality is, we all have competing demands on our incomes, and TFSA contributions can easily fall second place to other expenses, especially when left until the last minute.
So, what can you do to avoid the stress of last-minute investment contributions? In short, the answer is DCA – Dollar Cost Averaging.
Although a DCA strategy can be used for investing virtually any amount of money into any type of investment account, we’ll illustrate the concept with a monthly investment into an ETF portfolio held in a TFSA account.
Basics: The ABCs of DCA (Dollar Cost Averaging)
Dollar cost averaging (DCA) is a fancy way of describing a regular investment contribution strategy. More precisely, it is the practice of investing a fixed dollar amount, at regular, pre-determined intervals. In the context of the TFSA, and with the new $6,000 limit, the math is really quite straightforward – invest $500 per month. That’s the gist of it.
While it sounds simple, and is simple, a DCA plan actually offers many benefits, both financial and psychological.
Outperform…Without even trying
Since the number of dollars invested each month remains constant, the number of ETF shares (or mutual fund units) purchased fluctuates, based on the market value of the shares at the time of each purchase.
When the per share price of investment rises, fewer shares are purchased due to the higher cost per share. Conversely, when the per share price of the investment falls, a greater number of shares are purchased. That is, you end up buying more when the price is low, and less when the price is high. The net result is that you end up with a lower overall average cost base, and therefore, and overall higher rate of return.
So, while you might not “beat the market,” investing via a DCA strategy most certainly ensures you buy more when prices are down and less when prices are up. That might sound strange, but indeed, there is often a huge gap between investor performance and investment performance.
Time IN the market, not timing the market
It’s often said that, in investing, what matters most is time in the market, not timing the market. In the context of TFSA contributions, waiting until December to make your annual contribution simply means forfeiting a full year’s worth of tax-free growth. Conversely, if you make regular contributions throughout the year, you increase the amount of time for your savings to grow, tax free, inside the TFSA. If you think this is an insignificant difference, think again. By contributing throughout the year, you can earn thousands more in your account over the years.
Additionally, making large investments all at once can be very stressful. The stress typically comes from trying to figure out if now is the ‘right time’ to invest. Of course, in hindsight, the ‘right time’ is obvious. But trying to guess that time in advance can be very stressful indeed. On the other hand, investing with a DCA strategy can help remove the stress associated with making a single lump-sum investment, and reduce the risk of a significant downturn immediately after making a large investment.
Another powerful feature of a DCA investment strategy is that it allows you to keep your emotions out of the process. Emotions, and in particular, fear and greed, are typically an investor’s worst enemy. Human nature being what it is, we often cannot resist the urge to tinker with our investment plans to try and improve performance. Of course, this type of market timing almost always proves to be a mistake, and sometimes a very costly one at that.
Year after year, studies show that, in an attempt to time the market, most investors actually underperform what they could achieve, by getting in and out at the wrong time. As the famous investment guru Warren Buffet said, “To invest successfully over a lifetime does not require a stratospheric IQ, unusual business insights, or inside information. What’s needed is a sound intellectual framework for making decisions and the ability to keep emotions from corroding that framework.”
A DCA investment strategy offers a simple yet highly effective way to keep you from falling victim to your emotions – by keeping them entirely out of the equation.
The best way to commit to making regular TFSA contributions is to set up a monthly pre-authorized contribution plan. If you plan to make a $6,000 contribution to your TFSA this year, instead of waiting until the last minute and scrambling to find the cash, you can simply setup a pre-authorized contribution of $500 per month. That’s it – set it and forget it. Setting up your monthly TFSA contribution plan is a breeze with ModernAdvisor.
If you have any other questions about Tax Free Savings Accounts, setting up a DCA regular investment contribution, or about any of our other products and services at ModernAdvisor, just ask us.