Dollar Cost Averaging: Diversify

We have already covered how Dollar Cost Averaging (DCA) promotes investing consistency and discipline.

A third reason to use DCA is that it is great for building a diversified portfolio over time.

That is not to say that investors cannot build a diversified portfolio through lump sum investing. However, DCA can make the process easier and more consistent, especially smaller investors with limited resources.

Proportionate Ownership

There are many ready made investments that allow investors to periodically invest relatively small amounts. In return, these assets provide excellent low-cost diversification.

No load open-end mutual funds and exchange traded funds (ETFs) are two popular types of such investments.

With each small investment, individuals actually buy a piece of many different individual investments. Companies, bonds, currencies, real estate, etc.

Perhaps you have USD 1000 to invest. Instead of buying 100 shares of one company at $10 per share, you can get a proportionately smaller piece of 100 different companies. A great way for small investors to diversify within an asset class.

You can also buy funds that invest in a wide variety of asset classes and investment styles. Different levels of market capitalization, wide geographic distribution, growth versus value investing, alternative asset classes, and much more.

In today’s marketplace, there are a myriad of fund investment options.

And this promotes easy portfolio diversification.

Often Difficult to Buy One Unit

When buying individual assets, it is difficult to buy less than one unit.

If you want to invest directly in real estate, USD 1000 will not buy you much, if anything.

However, as at June 1, 2019, your USD 1000 will get you about 38 shares of the iShares Global REIT ETF (REET).

REET owns 296 different holdings around the world, in both developed and emerging markets. As well, investments cover a wide variety of sub-sectors, including: retail; industrial and office; residential; health care; hotels and lodging.

For a relatively small cost (current annual total expense ratio of 0.14%) you get substantial diversification across geographic regions, real estate sectors, and individual holdings. Not bad for your $1000.

The same difficulty in buying one unit can also arise with individual stocks.

While many public companies try to keep the price of their shares within reach of most investors (e.g., stock splits, initial public offering share price), there are still companies whose stocks have very high valuations.

For an investor with little money to invest periodically, that can pose a problem.

For example, perhaps you want to invest your USD 1000 in stocks. Your golf buddy told you that both Amazon and Google were great investments. However, on June 3, 2019, Amazon (AMZN) trades at USD 1705 while Alphabet (GOOG) has a share price of USD 1037. You may need to save for a few months before even buying one share of each company.

But if you invest that $1000 in the Vanguard Growth ETF (VUG), you acquire about 6 shares. Each share contains 6.2% of its proportionate portfolio holdings in Amazon and 5.5% in Alphabet. Plus relatively significant exposure to Microsoft (7.7%), Apple (6.5%), and Facebook (3.5%). And smaller weightings, but ownership, of another 295 growth companies.

Not bad exposure and diversification for your $1000. Not to mention, if you DCA at $200-300 monthly (or similar), you can add shares of a fund periodically and consistently over time.

Search for Specifics

Note that you can search mutual funds and ETFs by exposure. That way, you can find funds with significant holdings in companies, industries, sectors, markets, etc., that you specifically desire.

For example, you want to own Amazon but only have USD 1000. Not even enough for a single share. But how about something like The Consumer Discretionary Select Sector SPDR® Fund (XLY)? It trades around USD 111 per share and has a very reasonable expense ratio of 0.13%. XLY’s portfolio holds 64 different companies, but 25% of the ETF represents Amazon. Home Depot, McDonald’s, NIKE, and Starbucks, are other significant holdings.

XLY provides heavy exposure to Amazon (and discretionary spending sector). It meets your goal of owning Amazon. The issue may be that it owns (possibly) too much Amazon, so you lose diversification. Also, if consumer spending takes a hit, that may have similar impact on all these companies. As the saying goes, “a falling tide lowers all boats.” Perhaps a fund like XLY is better suited as a tactical play or to augment one’s overall portfolio. Less so a core portfolio holding.

Cost of Fund Acquisition

Funds can also be purchased in lump sum, so why are they an advantage for DCA?

Mainly in the method one can acquire funds.

Traditionally, an advantage of lump sum investing was the reduced transaction costs involved. Instead of paying multiple fees for each DCA purchase, investors could save money by only making a single large purchase. However, that advantage is disappearing over time.

Buy Free Directly From the Mutual Fund Company

Many mutual fund companies allow investors to buy extremely low amounts on a periodic basis through direct debits from the investors’ bank accounts. If purchasing directly from the mutual fund company, there are normally no transaction costs involved on no load funds.

For example, you may be required to invest a minimum of $5000 on an initial purchase. Subsequent purchases may then be made at a minimum of $50. If it is a no-load fund, then there will be no sales commissions.

Buy Mutual Funds With Waived Commissions from On-line Brokers

Or if investing through a brokerage account, there are many mutual funds and ETFs for which the on-line broker’s commission is also waived. The number of brokers offering these waivers and the number of commission-exempt funds available is growing.

While growing in number, factor that in as only one variable. Saving $9.99 (or less) in a transaction cost may not be worth it if there are better funds out there that do require the fee.

Shop Around for Best Rates on Mutual Fund Commissions and Transaction Costs

And for those funds that do require a commission to the broker, price competition has reduced fees substantially. The same holds true for brokerage fees on buying or selling ETFs or equities. While still a concern – every dollar paid out of your account is a dollar that will never compound on your behalf- transaction costs are impacting investors to a lesser extent these days.

But it does pay to shop around. Make sure you get best value for your investing requirements.

Dividend Reinvestment Plans

Another excellent way to grow an investment, while reducing cost, is through a Dividend Reinvestment Plan (DRIP).

Funds periodically pay out any gains or income to investors. Under a DRIP, instead of a cash distribution, the payment is reinvested in additional units of the fund. There are no transaction fess on the reinvestment.

Usually a great way to painlessly increase your investment. Not to mention the compound return impact as your reinvested income will also earn income over time and grow too.

That said, two caveats. If you are relying on income to live, no sense in reinvesting it. Also, most tax jurisdictions consider the income as taxable. Even if you do not physically receive it. Unless held in a tax-free or tax-deferred account, you will need to pay tax on income earned. Either hold DRIP assets in tax-effective accounts. Or be aware that come tax season, you are liable for income you did not receive in cash.

Summary

Small investors can easily build a diversified portfolio using DCA.

Mutual funds and ETFs allow small investors to invest in assets that they may not have the ability to do on their own.

No load mutual funds are a cost-effective way of accumulating wealth under DCA. This is especially true when investing directly through a mutual fund company. When investing via a brokerage house, be wary of any broker’s commission. Consider funds with waived fees.

ETFs are also effective, but one must consider transaction costs. Transaction fees on ETFs are generally lower than for mutual funds with loads, but they should still be monitored. There are also waived commission, or no-transaction fee, ETFs offered by brokers, so look for those.

But do not select inferior funds just to save a dollar or two on commissions. While you want to minimize investment expenses, you always want to acquire quality assets. Stronger returns will offset slightly higher commissions. So invest wisely both in costs and quality.

Finally, DRIPs can be an effective tool to grow your wealth. Unless you require the cash income, consider DRIPs for all eligible investments.