Episode 50: DCA: Quality
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.
All that and more in Episode 50 on the Wilson Wealth Management YouTube channel.
“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).
Yet, if you look at active manager performance, this is relatively rare.
“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.
Essentially, as we discussed in “Episode 39: Passive Investing Keys”.
“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.
For a little more on this overall topic, please refer to “Dollar Cost Averaging: Quality”.