Let us turn our attention on how you should invest.
That is, how you will accumulate assets to 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.
We will look at these today.
Lump Sum Acquisitions
In lump sum investing, you accumulate your capital and purchase 100% of the asset concurrently. 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 slowly, invest your growing reserves in highly liquid assets (money market funds, etc.) to earn a little income on your cash reserves while you wait.
For example, you have $20,000 and wish to buy 1000 shares of Intel Corporation at $19.99 per share. You invest through an on-line broker in the U.S. charging $10 per trade. With the extremely low commission, your weighted average cost (WAC) per share is only $0.01 more, $20 per share.
Dollar Cost Averaging
With dollar cost averaging (DCA), you do not purchase 100% of your desired investment all at once. Instead, you amass your investment over time.
Why would you do this?
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 time. 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). So you need to exercise a little common sense when employing DCA.
In our example above, you want to accumulate 1000 shares in Intel. But you do not have $20,000 available. However, over the next year you will receive $5000 quarterly from a rich aunt. You decide to use those funds to acquire Intel shares every 3 months.
If the share price of $19.99 stays flat over the year, you will lose a little versus a lump sum investment. That is because most low-cost on-line brokers charge a 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. That would bring your WAC to $20.03.
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.
If during the 12 month period Intel appreciates in share price, then you lose even more with DCA. Instead of buying all your shares at the initial price of $19.99 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.
Say on January 1, Intel trades at $19.99. You invest $5007.50 and buy 250 Intel shares with $10 commission. On April 1, Intel trades at $24.95, so you purchase 200 shares for $5000. On July 1, you are able to buy 150 shares at $33.27 per share. And on October 1, you buy 100 shares at $49.90. At December 31, Intel trades at $50 per share.
With DCA, you accumulated 700 shares of Intel at a total cost of $20,007.50 and a WAC of $28.58. Compare this with the initial lump sum investment that brought 1000 shares with a $20 WAC per share.
Further, at December 31, the lump sum approach shows an unrealized gain of $30,000. Whereas the DCA method only results in unrealized gains of $15,000.
Depreciating or Fluctuating Asset
Where DCA shines though is in down or fluctuating markets.
Say you bought as above, but the share price was $16.63 on April 1, $12.47 on July 1, $18.15 on October 1, and $22 on December 31. A more common scenario than watching a stock steadily climb from $19.99 to $50 in one short year.
Under DCA, with a $5000 quarterly investment, you would have accumulated 250 shares January 1, 300 shares April 1, 400 shares July 1, and 275 shares October 1. With the price fluctuations over the year, you would have amassed 1225 shares for your $20,000. More than under the lump sum approach.
Additionally, the lump sum would show unrealized gains of $2000. Not bad. A 10% return for a one year investment of $20,000.
But the DCA strategy would have resulted in unrealized gains of $6950. A much better result.
Is Either Approach Better?
From the examples above, it should be clear that when assets are appreciating in value the lump sum method is preferable.
In down markets, or where there is uncertainty over the short to medium term value, DCA might be the best method.
Next we will look at this issue in a little more detail.