We have now compared Lump Sum versus Dollar Cost Averaging (DCA) investing. Lump Sum may outperform in long run returns. DCA may prove better for “smaller” investors and in dealing with shorter term market volatility. DCA may promote investor consistency and discipline. DCA may also help create well-diversified, high-quality investment portfolios.
“Does Lump Sum investing provide superior long-term growth?”
Yes. With a few caveats.
Studies tend to assume that Lump Sum investors have cash readily available to invest on day one. In reality, most investors do not have funds to invest up front. It may take time to accumulate cash to make the lump sum investment. And that needs to be factored into the calculations. Often, it is not.
In the long run, assets appreciate. But in the short to medium terms, you will face significant volatility. When you invest and your holding period can greatly impact portfolio returns.
“How can DCA assist is dealing with short to mid-term volatility?”
If you possess strong market timing skills, then Lump Sum is great to take advantage of price swings.
Unfortunately, even the professional asset managers are not very good at timing market movements.
DCA does help smooth out price volatility in your portfolio. Because you are investing a fixed amount each period.
Investing $1000 every 4 months? On January 1, the investment trades at $10. You are able to purchase 100 shares. On May 1, the asset trades at $20. Your $1000 only buys 50 shares. On September 1, the asset trades at $4 and you buy 250 shares. At December 31, you own 400 at an average cost of $7.50. A lower adjusted cost base than if you had invested the $3000 at $10 per share on January 1 and received 300 shares.
Of course, if there was no volatility, only straight growth from $10 to 15, DCA would underperform.
And yes, there may have been dividends missed that also impact total return. And the additional transaction costs. So there are other factors to consider when comparing.
Most investors do not have cash sitting around, waiting to be invested. Lump Sum investing, while perhaps providing better performance, may not be practical for the average investor.
If it takes 6-12 months to save before making a Lump Sum purchase, that negates some of the outperformance versus DCA.
“How can I improve investing consistency and discipline by using DCA?”
Consistency and discipline go hand in hand.
Consistency is more about the actual process. If you set up a system where you automatically invest $300 per month, that is consistent.
It also has a behavioral finance aspect. Like a phone bill or Netflix account, you adjust to having $300 less disposable income every month. In short order, you “forget” about your investing funding. Compare with having to find $3600 on January 1 for a lump sum investment. A bit different on the mindset.
Discipline, to me, is more the emotional side of consistency. Markets are up. Will they fall? Should I buy into a bull market? Especially if “television talking heads” are warning of a correction. Markets are down. Should I buy when everyone else seems to be selling? Maybe I should wait until the bottom is reached and things are picking up again.
As opposed to just investing that $300 per month and not worrying about the short term ups and downs. A smarter way to build a portfolio. And definitely helps with emotional discipline when your stomach (and the “talking heads”) are creating uncertainty in your actions.
You can effectively diversify a portfolio under Lump Sum.
But it is something that works very well with DCA. Especially for smaller investors.
Mutual funds are usually set up for small investors, making periodic investments of relatively low amounts. You also can receive partial units in a fund, allowing you to invest all your capital immediately.
While not the same process with Exchange Traded Funds (ETFs), often pricing of ETFs is such that buying shares is not an issue. You tend not to see ETFs priced like Google (USD 2526 at June 28, 2021) or Amazon (USD 3430). Instead for diversified ETFs, prices are more reasonable. If we look at iShares, we see the Dow 30 (IYY at USD 108), S&P 500 (IVV at USD 428), rest of developed world in EAFE (EFA at USD 80), or Emerging Markets (EEM at USD 55).
We also see that ETFS and mutual funds offer almost every possible investable market. Small cap or mega? Value or growth? Specific sectors? Individual countries? And so on. Usually at reasonable share prices for all investor levels.
“Finally, how can DCA help improve my portfolio quality?”
Investing in “quality” assets is actually more difficult than it seems.
If professional money managers could consistently pick the winners, they would easily outperform their benchmark indices. Which hold both the good and bad assets. And, as we have discussed, there are reasons why outperforming is hard.
A DCA strategy works best in a passive approach. Investing in index funds. For most indices, there are minimum requirements to be included.
For example, the S&P 500 is essentially the largest 500 companies traded on the NYSE or NASDAQ. Essentially, as there are some other criteria, including positive earnings over time. As once-dominant companies weaken, they are replaced on the index with up and comers.
In 1999, long-term dominant companies Goodyear Tire, Sears & Roebuck, and Chevron all left the Dow 30. Replaced by Microsoft, Intel, and Home Depot. In 2015, AT&T, a Dow component since 1916 departed. In its place, Apple. And so on.
Also, indices like the Morningstar Dividend Yield Focus Index rely on screening criteria for index inclusion. In this case, Morningstar takes its US Market Index components (97% of US equity market stocks) and screens them for the top 75 dividend producers. Criteria reflect financial health and dividend related areas. As it is only 75 holdings, it is easy for the bottom tier to vanish and new stocks to enter over time.
While you may only hold the single index, there will be turnover of the underlying assets.
How can Dollar Cost Averaging (DCA) improve investment quality versus Lump Sum investing? While investors can still find quality assets under a Lump Sum strategy, DCA is very useful in building quality portfolios. Especially for smaller investors.
“Why do you believe that investment ‘quality’ is an elusive concept?”
We have seen this in previous episodes and posts.
If identifying quality investments was simple, then professional asset managers should easily outperform their passive index benchmarks. If I can readily pick the best companies on the S&P 500, I should be able to surpass the performance of all 500 holdings. Even in a capital weighted index (as most are).
“How can I improve my odds of investing in quality assets?”
If you cannot beat the market on a consistent basis, then match the market.
In general, the index itself will tend to have higher quality holdings. Usually, there are criteria for inclusion on an index. And sheer size of a holding also impacts its relative weight in an index, assuming a capitalization-weighted index (as many are). So the holdings themselves, may have some quality.
But quality comes in creating a well-diversified investment portfolio. One that meets your Target Asset Allocation, that is derived directly from your Investor Profile.
A portfolio with minimum tracking error, so that it closely matches the index return. And with low-cost investments, so that your funds grow on your behalf. Not in your bank or fund company accounts.
“You said that ‘quality’ is ever changing. Any examples?”
We look at two companies. One, joined the Dow Jones Industrial Average (Dow 30) in 1930. A dominant company over the decades. In the 1970s, held market share of 85-90% in its key market sectors. Yet, in 2012 it went bankrupt.
The other, a penny stock in the 1980s. Fired its Chief Executive Officer (CEO). Other key employees left. Not perceived as a great investment. In 1997, the original CEO is rehired. In 2015, the company joins the Dow 30. An index commonly viewed as the most prestigious companies in the United States.
Quality can change over time. And often quite quickly, once the shift commences.
“If I buy a plain-vanilla index fund, am I not stuck with the same holdings forever?”
Not at all.
As I mentioned above, most indices have certain criteria for inclusion. As a company’s fortunes rise, it will begin to be included on different indices. As a company slips, it will be removed from an index. And replaced with the stronger company.
In the YouTube episode, we see how much change can take place on the Dow 30 over the last 20 years. Only 30 holdings, but substantial churning within the index.
In buying the index, you own one investment. But the actual investments held within that index may alter over time as asset fortune’s rise and fall.
Also, with market capitalization-weighted indices, relative holdings will shift over time and differ.
When I wrote “A Real Fund Diversification Problem” in June 2020 (one year ago), the top 12 companies of the 500 on the S&P 500 accounted for 29.1% of the total holdings. The bottom 400 companies accounted for 29.6%.
Those ratios are consistent today. In June 2021, the top 12 holdings make up 28.9% of the S&P 500.
As an aside, if you think you are getting exposure to 500 companies (or whatever an index has for holdings), there is a good chance you are not. Currently, 12 stocks have the same impact on the S&P 500 index as do 400.
For more information on this index compositions, I suggest reading “Diversification and Index Weighting”. Very useful to understand the level of actual diversification in a fund.
“So I do not need to review my portfolio?”
While your holdings may shift, you do still need to review the overall portfolio.
Perhaps your personal circumstances have changed, necessitating an adjustment in your Target Asset Allocation. That may require asset class allocation shifts.
Over time, one asset class will outperform another. Maybe your target weight for US equities is 30%. Now you are at 45%. You will need to adjust your positions.
Maybe a new index fund has been created since your last review. Less cost, better tracking. What may have been “best in class” when you initially invested, may change in quality over the years. Had you invested in a fund in 2000, you will find the product landscape – offerings and costs – much different today.
An advantage of Dollar Cost Averaging (DCA) versus Lump Sum investing is that it may help investors better diversify investment portfolios. A look at why DCA may benefit diversification efforts.
I will say, up front, that you can properly diversify an investment portfolio using a Lump Sum approach. But for smaller investors, the typical investor like you and I, DCA can make it easier to diversify.
“What is proportionate ownership?”
Proportionate ownership means owning pieces of an asset. If you want to invest in shares of Google or Amazon, you need USD 2421 and USD 3233 to buy one share each as at June 1, 2021. If you only have USD 500, you cannot purchase 25% of a Google share.
In today’s equity markets, you need a fair amount of capital to buy shares in a variety of companies, industries, and markets to diversify. Which is the big argument for mutual and exchange traded funds. Built in diversification at reasonable prices.
Plus, with mutual funds, you can buy partial shares or units. And very quickly, your fund statements will be filled with owning 128.9245 and 244.1877 units of a fund.
As well, with funds and even stocks, if you sign up for dividend reinvestment plans (DRIPs), any dividends issued will be automatically reinvested in additional units or shares.
“If I can diversify under Lump Sum, where is the advantage in using DCA?”
Yes, you can diversify using Lump Sum. But diversified investment products tend to be geared for DCA investors.
You can easily purchase partial shares or units in mutual funds.
Fund companies typically offer very low purchases once you are in a fund. For example, a mutual fund may require a minimum initial purchase of $1000 (or $2000, $5000). But subsequent purchases are often as low as $50 (or $100, etc.). You cannot do this with Google, Amazon, or even publicly traded ETFs.
And, as you should be investing in no-load funds, there will be no sales commission or transaction fees when you make those low dollar value subsequent investments. Keeping your costs down.
Add in convenience options, such as automated direct debits, DRIPs, tax and performance statements, etc., makes it very easy to create a portfolio that is easy to manage and monitor.
“What are asset-weighted indices and equal-weighted indices?”
Asset-weighted indices, also known as market-capitalization or market-cap, reflect an index that is weighted based on the capitalization of each holding in the index.
An equal-weighted index does not reflect the relative market size of a specific holding.
Consider the S&P 500 index. 500 companies. Under an equal-weighted index, each holding would have a 0.2% investment.
But the S&P 500 is an asset-weighted index. If we look at the relative investments, the top 10 holdings make up 27% of fund capital. That is roughly the same amount of fund capital invested in the 400 smallest companies on the index.
There are pros and cons to each approach. Should Apple, Microsoft, Amazon, and Facebook be treated the same as The Gap, Ralph Lauren, Cabot Oil, or Alaska Air? Probably not.
However, investors who think they get incredible diversification in owning 500 different companies are mistaken. Still a lot of diversification. But more like 40 to 50 stocks, not 500. And probably 20 really can drive the index.
“What about if I want to invest by specific styles?”
Yes, DCA can still diversify outside plain-vanilla generic index funds.
There are many indices that are broken out by investment style. Or, an index is divided by style.
For example, iShares USA. A large ETF provider, with many funds. IVV is iShares plain-vanilla S&P 500 index fund.
If you are interested in value or growth stocks, then iShares offers two funds that split out the S&P 500 growth (IVW) and value (IVE) stocks. If you are not interested in the larger capitalization of the S&P 500, iShares offers small and mid-cap index funds. Or funds that focus on dividend producers.
“Or in alternative assets and hot trends?”
Firstly, investors often get exposure to alternative asset classes within plain-vanilla index funds. If we look at the Toronto Stock Exchange and its TSX Composite. Canada is a country heavily into natural resources. The index alone has 13% in Materials, 13% in Energy, 3% in Real Estate.
Brookfield Asset Management is the 7th largest holding on the TSX. Considered a “Financial” company, it is much more than that. A global company. Its key business lines are real estate, infrastructure, renewable power, and private equity. Brookfield, alone, provides investors with exposure to niche markets and hot sectors. All wrapped up in a plain-vanilla index fund.
That is a big reason why investors typically do not need to add specific alternative or exotic investments to their base portfolios. Create a well-diversified portfolio foundation. The niches will be built in.
But if you are set on investing in niche or hot sectors, there are a ton of index funds.
Again, using iShares as an example. Environmental, Social, and Governance (ESG) index funds. ESG is a very hot investment trend. Low-Carbon and Self-Driving Electric Vehicle index funds. Various commodity funds. And so on. There tends to be passive index funds available in any flavor an investor wishes.
Another advantage of Dollar Cost Averaging (DCA) is that it may better promote investing discipline than Lump Sum. What is “investing discipline”? How is it beneficial for investors in building wealth?
“What is ‘investing discipline’? Is that not the same thing as ‘consistency’?”
Investing discipline and consistency are related. But there are a few important differences.
In a perfect world, investors create comprehensive investor profiles that drive target asset allocations that reflect the individual’s unique circumstances. That leads to creating a personalized investment portfolio. One that is built in a structured way over time.
In the real world, this often does not happen.
Now, DCA may not assist in the target asset allocation. But it can help you better “stay the course” in building a structured investment portfolio.
“How can DCA help me improve my investing patterns and behavioural issues?”
If you intend to invest $400 per month into your asset allocation. That is consistency.
The DCA discipline factor is in “staying the course” during real or expected turbulence.
Maybe markets are at all-time highs and you are worried about a correction. If you think markets are overheated, should you invest that $400 or wait until after the crash?
Maybe everyone is buying heavily into a stock or sector and you have a “Fear of Missing Out”. Should you also jump on board the hype train?
Emotions and outside influences can easily creep into investment decisions. Causing you to deviate from planned funding patterns. Adhering to a disciplined investing plan will help minimize that side of the equation.
It will keep your investing consistency by being disciplined.
As an added bonus, your increased investing knowledge will also help maintain your discipline. How often, in previous episodes, can we seen that the ability to properly time market fluctuations is poor.
Even for investment professionals who actively manage portfolios. It is actually difficult to pick winners and losers and time markets. As well, we saw that missing out on only 5 or 30 of the best days, leads to significant negative impact on returns. That understanding of investing realities will also help you better “stay the course” when your gut is begging you otherwise.
“What other things can help maintain discipline?”
We will review investment quality in a future episode, but that is a big factor in maintaining discipline.
Part of the discipline breakdown relates to (perceived) poor investments or ones that have reached their peaks or valleys. Should I sell? If so, invest in what? Should I buy more in a down market as this asset will rebound? Or should I sell because it will never return to its previous value?
Investing in quality assets reduces these concerns. Now, what is a quality asset? That is the question we will cover later this month.
Another potential advantage of Dollar Cost Averaging (DCA) versus Lump Sum investing is consistency. DCA helps investors promote a more consistent investment approach. Crucial for long-term investment success. But a characteristic lacking in too many investor philosophies and strategies.
“Does that mean that all Lump Sum investors are inconsistent?”
No. Although there is a higher probability of inconsistent investing under Lump Sum.
With Lump Sum, there are three approaches.
You already have cash on hand. You review different investment options and invest 100% on day 1.
You need to accumulate cash over 3, 6, 9 months. Once you reach a critical mass, you research investments, and then invest 100% at that point.
You have identified an investment you wish to purchase. You then accumulate cash over time and invest 100% when you reach a critical mass.
The first option is best, though most investors do not have excess cash sitting there to invest. Option two is more common. You decide to invest, start saving, then find the “best” investment when you have saved enough cash. Option three is also common. The problem is that if it takes 12 months to amass capital, is it still the “best” investment a year out? Investors should do another review before buying.
Now, yes, investors using these strategies can be consistent. But life often gets in the way. As they are saving to invest, maybe the car breaks down. It is a cold winter and that $3000 you have already saved can help pay for a Hawaiian vacation.
Now compare that with simply setting aside $200 per month and investing every month or two.
In the real world, which approach will prove more consistent for most individuals over time?
“Can you explain more about behavioural investing and DCA?”
Part of investor behaviour is discussed above. Will investors have the will-power to save and consistently make Lump Sum purchases?
On the other side, DCA should become more like your utilities or cable bill. It is just another monthly expense that you adjust to over time. Hopefully, one that becomes painless in a year.
The amount contributed can be relatively low in your early years. But increase as disposable income rises. Again, DCA takes away human behaviour and promotes consistency.
“DCA really seems like a “no-brainer” approach to easily build wealth. Is it?”
Easy, yes. A “no-brainer”, not quite.
That is a problem for some DCA investors. They just set up an investing program, contribute on a consistent basis, and forget about it until maturity.
Even investing in well-diversified, low-cost, index funds requires continuing maintenance. Over time, your overall asset allocation will be out of sync with your planned target allocation. Depending on your personal circumstances, your target asset allocation may need adjustment.
Perhaps that “best in class” fund that you researched and started investing in 10 years ago is no longer high quality. New, improved products always come along that bear comparing. Maybe your wealth has increased and you should add other complementary products to your original portfolio foundation.
And so on.
Yes, DCA is useful and promotes a consistent investment approach. But there is more to the investment process than just ongoing funding. We will cover portfolio reviews and rebalancing in future episodes.