How do you build an efficient and effective investment portfolio? What type of investment accounts to open? Are there other methods to build wealth over time outside your own accounts? What is the “Lump Sum versus Dollar Cost Averaging” debate?
To date, we have covered investor profiles and how they drive the target asset allocation. We have also reviewed the asset classes, different types of investment options, and whether to actively manage your assets or not. We can now take all that knowledge and begin to construct an investment portfolio.
In Episode 43, we consider the following questions:
“What type of investment accounts should I open and where?”
We discuss where you should maintain your investment accounts.
With your current financial institution, where you have your chequing account? Should you consider a speciality or independent brokerage house? Or with a mutual fund company?
“What about tax-efficient accounts?”
We look at the differences between taxable and tax-efficient investment accounts.
For most investors, annual and cumulative contribution limits are often high enough that taxable accounts are not needed. But that will vary between jurisdictions.
“Will I need a margin account?”
There are pros and cons to setting up margin accounts versus cash accounts.
A margin account allows you to leverage your portfolio. In an up market, leverage can be useful as it boosts returns. However, in a down market, or where the investment in question declines in value, that can create problems.
“What other investment options may exist?”
Often, employers provide employee pension plans. These may be defined benefit, where upon retirement you receive predetermined periodic payments from the pension plan. Or defined contribution, where the employer (and perhaps employee, as well) makes periodic monetary contributions into the plan. Upon retirement, the employee receives the value of the total contributions and investment return growth.
Employers may offer Employee Stock Purchase Plans (ESPP). Or stock options to key employees.
You may be able to invest directly with public companies, with no transaction costs. Direct Stock Purchase Plans (DSPP), convertible assets, warrants, and options, are a few examples.
Finally, there are often Dividend Reinvestment Plans (DRIP) for investments you acquire. The DRIPs allow investors to automatically reinvest any distributions (e.g., dividends) into the investment, rather than receiving cash.
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.
Over time, we will look at the debate between active and passive asset management.
What each term means. In general, should you actively or passively invest? Are there exceptions to the general rule?
Today I want to briefly highlight an article I read in the Financial Times. A subscription is probably necessary to access the story, but I will cover the key points below.
Active Global Equities Outperform
The Financial Times article is entitled, “Study finds active global equity funds outperform”.
Very interesting given that it is very difficult to impossible for active managers to consistently outperform market benchmarks over extended periods. There are some exceptions, yes. But, in general, I would not expect to see actively managed global equity funds outperform their passive benchmarks.
But if the Financial Times headlines that, it must be correct. Sell all your index funds and get into actively managed. Unfortunately, if you read past the headline and opening paragraph, it is not that clear cut.
Many “Studies” Desire Pre-Ordained Results
According to the study,
actively managed global equity funds outperformed the market by between 1.2 per cent and 1.4 per cent annually on average between 2002 and 2012.
I will not impugn this study and shall accept their results.
But it is worth pointing out a problem I have found with “studies” in many instances. Something you should keep in mind any time someone claims something, especially an unconventional finding.
In this study, why choose only a sample period from 2002 through 2012? Did active fund management not exist before 2002? Yes it did, in case you were wondering. Why end in 2012 for a study that is just being published now? 4 years to assess and collate?
Watch for studies that rely on things like sample size, time period, or makeup of the participants to drive the results. In general, the larger the sample size or time period the better. Or with “makeup”, consider a poll of US voters that has a sample of 85% Democrats to 15% Republicans. You may not get a representative set of responses of the US as a whole.
The same holds true for sampling investments. You always want samples that represent the overall population as best as possible.
Again, not saying there is anything intentional here, but it raises questions. Especially given that it is very difficult to consistently beat benchmarks over longer periods.
Always view “studies” with a healthy degree of skepticism.
Investor Costs Impair Performance
I am not going to hammer the findings too much as active management can outperform in gross returns. Sadly, you – the investor – never receive gross returns. For the active managers’ services, you pay an annual management fee, plus associated costs. Your return is net of fund costs and fees.
You may have also paid a sales commission when you bought the fund. That adds to your cost structure.
This study found that active management can outperform on a GROSS basis. The study does not calculate excess returns on a NET basis. That is, the actual return that you receive. When you factor in management fees that investors pay in the real non-academic world, that 1.2% outperformance significantly shrinks.
I do not know the exact shrinkage as I do not know the specific funds assessed. But it would not surprise me if the management fees and related costs eroded the excess return to zero of worse.
The article points out that “pension funds and other big investors typically pay fees of around 0.75 per cent.” Then helpfully adds, “Retail investors often pay higher fees.”
You, gentle reader, are a retail investor.
Investopedia gives a quick breakdown of typical fund expenses that lower investor returns. Investopedia estimates that, “The average equity mutual fund charges around 1.3%-1.5%. You’ll generally pay more for specialty or international funds, which require more expertise from managers.”
If that is the average equity fund, and international funds tend to cost even more, then that 1.2% excess return in an actively managed global fund disappears quickly.
Note that active management tends to result in higher administrative and transaction costs than a passive fund. Because active funds are more “active”. Also, many international funds have higher expense ratios for a variety of reasons (regulatory, lack of transparency, inefficient markets, etc.). We will cover this in time.
Realize that your net returns (i.e., your actual performance) may be materially different than gross.
Selection Bias
Another topic to delve into at a later date. But an issue with studies of this sort, so I will briefly touch on it.
The authors looked at 143 global equity funds. Now there are more than 143 actively managed global equity funds out there, so first question is how did they choose the ones they did? Did they pick the top performers, bottom performers, etc?
If you let me look back at 10 years results, I might be able to put together a portfolio of stocks with Apple, Amazon, Under Armour, SalesForce, etc. If you ask me to put together a portfolio for success in the next 10 years, I will have less certainty.
Second, and a huge issue with mutual funds, is funds that are no longer in existence. This study chose funds that were around for all 10 years of the study. That means funds that ceased to exist during that period were not included in the results. As you can imagine, the main reason for a fund ceasing to exist is due to underperformance. Weak funds lose investors (and their capital) and usually go out of business over time. By not including low performing funds in the sample, you skew results upwards.
Think back to your school days. 30 students in class. Mid-term exam, 10 students get 80%, 10 get 50%, and 10 get 20%. Overall class average is 50%. But the lower tier students all decide to cancel the class. Same class, but instead of a 50% average, now you only have 20 students who average 65%. Simply by weaker students dropping out, the overall average rises.
Same thing with funds. Never forget that when reviewing longer term performance data.
All the Media Clickbaits
The Financial Times is not TMZ or a dodgy website that lures viewers through very enticing headlines. Yet today, everyone uses headlines to attract readers.
Even staid financial newspapers or magazines are in the business of bringing people to their sites. That leads to headlines and short blurbs that may not be 100% accurate. Do not automatically assume that what you see in the first paragraph totally agrees with the actually contents. Make sure you read things in total.
These things tend to annoy me a great deal (hence the blog post). One, they tend to be incorrect or misleading. That confuses non-professional investors and leads them to make poor choices. Two, it takes me (and other financial advisors) time to correct this misleading information with clients.
Over time, and in some sort of proper order, we will get into the themes raised in this post. The active versus passive debate being the big one. But we will also take a look at fund fees and expenses and problems with reported performance data.