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.
All that and more in Episode 49 on the Wilson Wealth Management YouTube channel.
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.
For more on index weightings and potential concerns, please read “Diversification and Index Weightings” and “A Real Fund Diversification Problem”.
“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.
For a little more on this overall topic, please read “Dollar Cost Averaging: Diversify”.
