We now turn our focus on how to begin actually investing.
That is, how to accumulate bankable assets and create a well-diversified portfolio.
Generally, you have two options when investing.
Either you make lump sum purchases or you engage in dollar cost averaging.
Yes, there are also direct stock purchase plans (DSPP), employee stock purchase plans (ESPP), dividend reinvestment plans (DRIP), convertible debt or equity, etc. But those are relatively minor in the scheme of acquiring bankable assets. We will touch on them separately. For now, let us compare lump sum versus averaging.
Lump Sum Acquisitions
In lump sum investing, you accumulate your capital and purchase 100% of the asset at once. Depending on your cash flow and reserves, you may have the necessary funds in place to acquire all the desired amount up front.
Or you may need to slowly amass cash over time before making the acquisition. If amassing, invest your growing reserves in highly liquid assets (e.g., money market funds, etc.) to earn a little income on your cash reserves while you wait.
Maybe you have the funds in place, but are just waiting and watching for the right time to buy. Perhaps after a correction or when your analysis indicates an upwards price movement is near. In other words, market timing.
For example, on January 1, you have $20,000 and wish to buy 200 shares of Bank of Montreal (BMO) at $99.95 per share. You invest through an on-line broker charging $10 per trade. With the extremely low commission, your weighted average cost (WAC) and adjusted cost base (ACB) is $100 per share.
If you do not have the $20,000 right now, you would save until you do. Then buy all the shares at once.
Pretty straightforward.
An important thing to note is that with most online brokers, you pay one flat fee per transaction. Buy one BMO share for $99.95, you pay $10. Buy 200, you still pay only $10. The more shares you purchase, the lower the impact of transaction costs. A big change from the full service brokerage days.
Dollar Cost Averaging
With dollar cost averaging (DCA), you do not purchase 100% of your desired investment all at once. Instead, you build your investment consistently over time.
Why would you do this? Especially as I just wrote that the more shares you purchase at one time, the less impact of transaction costs on a per share cost basis.
Why you would do this relates to your ability to time the market. Or, rather, the difficulty in timing market movements.
Maybe you do not have the necessary funds to invest up front in a lump sum. Rather than accumulate cash over time and buy 100% of your investment at once, you prefer to buy piecemeal and build your desired position slowly.
Or perhaps you have the cash but want to invest over an extended period. Possibly due to uncertainty over short-term performance of the asset.
Obviously this technique works better for some asset classes (e.g., common shares) than others (e.g., real estate or diamonds – not sure someone will sell you a house or stone, piece by piece over time). So you need to exercise a little common sense when employing DCA.
In our example, you want to purchase 200 shares in BMO. But you do not have $20,000. However, over the next year you will receive $5000 quarterly from a rich aunt. You decide to use those funds to acquire BMO shares every 3 months.
Flat Asset
If the share price of $99.95 stays flat over the year, you will lose a little versus a lump sum investment. That is because of the fixed fee for each trade, regardless of shares traded. If you invest each quarter for one year at a $10 commission per trade, you will pay a total of $40 in fees. Had you bought in one transaction, only $10.
It may not seem like a lot, but over time that extra cost can add up in lost compound returns.
And the more trades required to reach your goal, the greater the commissions paid.
There are exceptions to this. Investing in certain no-load mutual funds directly through the fund company may not trigger any transaction fees. Some on-line brokers waive transaction fees on certain mutual funds and exchange traded funds. Also, enrolment in stock purchase plans and dividend reinvestment plans may also be transaction free.
In a flat market, not much difference between DCA and lump sum. Extra transaction fees and perhaps less dividend income under DCA. But if you are parking your cash will waiting to buy, you may earn some interest income to offset.
Appreciating Asset
If during the 12 month period BMO appreciates in share price, then you lose even more with DCA. Instead of buying all your shares at the initial price of $99.95 per share, you will need to pay more per share as the asset increases in value. With a fixed budget of $20,000, that will result in less shares purchased.
January 1, BMO trades at $99.95 You invest $5007.50 and buy 50 shares with a $10 commission. On April 1, BMO trades at $103.80, so you purchase 48 shares for $5000. On July 1, you are able to buy 45 shares at $110.89 per share. And on October 1, you buy 42 shares at $118.81. At December 31, BMO trades at $124.75 per share.
With DCA, you accumulated 185 shares of BMO at a total cost of $20,007.50 and a WAC of $108.15. Compare this with the initial lump sum investment that brought 200 shares with a $100.00 WAC per share.
Further, at December 31, the lump sum approach shows an unrealized gain of $4950.00. Whereas the DCA method only results in unrealized gains of $3071.25.
In a bull market, lump sum should outperform DCA.
Depreciating or Fluctuating Asset
Where DCA shines though is in down or fluctuating markets.
Say you bought as above, but the share price was $95.46 on April 1, $97.84 on July 1, $92.41 on October 1, and $89.00 on December 31. A more common scenario than watching a stock steadily climb from $99.95 to $124.75 in one short year.
Under DCA, with a $5000 quarterly investment, you would have accumulated 50 shares January 1, 52 shares April 1, 51 shares July 1, and 54 shares October 1. With the price fluctuations over the year, you have amassed 207 shares for your $20,000. More than under the lump sum approach. And with a WAC of only $96.62 per share.
Additionally, the lump sum would show unrealized loss of $2000. But the DCA strategy would have resulted in unrealized losses of only $1280. A much better result in a bear market.
Or even if BMO rebounded to break even of $99.95 per share at year end, DCA wins out. Your lump sum purchase of 200 shares at 99.95 would be equal to your cost. But the 207 shares acquired under DCA would now be worth $20,690, resulting in an unrealized gain.
Is Either Approach Better?
From the examples above, it should be clear that when assets are appreciating, the lump sum method is preferable. And if you are investing, you anticipate asset appreciation over the long term. So an early lump sum may be smart.
But in short to medium terms, there can be significant volatility in markets and asset prices. If you look at almost any stock over (say) a 3 to 5 year period, there will be ups and downs. Stocks seldom move higher in a linear manner. The more risky the asset, the greater the volatility. In these conditions, DCA might be the better wealth building method.
We will look at this issue in a little more detail.
