We have seen that Dollar Cost Averaging (DCA) is a great tool for small investors.
Today we will look at a second advantage.
Namely that DCA promotes a consistent investment approach.
Something that greatly assists in achieving long-term investment success.
And something that the majority of investors lack in their investment activities.
Lump Sum Investing Options
With lump sum investing, you can do three things.
One, you have cash on hand, find a suitable asset, and then invest. The preferred method, but unfortunately most investors do not have cash reserves sitting around.
Two, you slowly accumulate cash over time. When you have a critical mass saved you decide to invest. You look around for recommendations from analysts, media talking heads, or your brother-in-law. Maybe you find something good, maybe you do not. Maybe it fits into your overall portfolio, maybe it does not. But you have waited long enough, so you buy something.
Three, you identify an asset to acquire and begin to accumulate funds with which to buy it. Maybe it takes 6 months to save enough before you can make the purchase.
But much can change in 6 months. Perhaps the investment’s potential has fallen. Or perhaps comparable investment opportunities have improved in value. What looked like the best investment option 6 (or 3, 9, 12, etc.) months ago when you did your research, might not be the optimal asset when it comes time to actually invest.
At the time you wish to invest, you must always need to do your analysis again. Do not rely on stale research when determining if the asset should be in your portfolio today.
Some investors possess the discipline to accumulate cash over time for investing. But often cash is tight or other priorities arise and the capital never materializes.
DCA is More Consistent
With DCA, you consistently invest a fixed amount at pre-determined periods. The amounts and intervals may change over time, but DCA promotes consistent investing patterns.
The idea is that as you continually set aside a relatively small amount of money each period, you will get used to its absence. The money allocated to your investment account is like your monthly telephone bill or utilities statement. The costs automatically come out of most people’s bank accounts each month and they live on what remains.
If you do the same with your investing, soon you will not feel the pain of the monthly contributions. And, when you see the results, it will positively reinforce your decision.
DCA Builds Solid, Diversified Portfolios
I like DCA because you identify solid investments and slowly build up solid portfolio positions.
Of course, like my previous comment, a lot can change over time. What was solid today may not be in 6 months. Prudence and ongoing due diligence must be used in any investing methodology.
That is why DCA is well suited for continuous investments in ready-made diversified assets. Assets that include a variety of individual investments and whose performance attempts to reflect market returns as a whole. Investments such as no-load index mutual funds or exchange traded funds (ETFs).
Yes, I realize that I am constantly beating the funds drum. But funds should be the cornerstone of most investors’ portfolios.
DCA is Cost-Effective with Diversified Assets
I prefer DCA for fund purchases as opposed to single asset acquisitions.
Let us say you want to build an equity portfolio with 30 stocks of equal weight. A reasonable number for diversification purposes if chosen wisely.
Further, you intend to invest $300 per month in these stocks.
You could allocate $10 to invest in each stock every month as a fair breakdown. But the commissions alone, even from the cheapest online broker, would bankrupt you.
Or you could spend the $300 each month on a different stock, rotating through the desired portfolio every 30 months. A better system. However, if you wish to acquire Apple at $360 per share, you are either out of luck or must allocate more than one month’s allotment to it.
Or you could do a million other permutations to build your desired portfolio over time.
Or you could simply find a no-load fund or ETF that holds relatively high concentrations of the desired shares, or similar asset classes, and invest in that fund.
Each month your $300 will get you a pro rata share of the fund’s holdings. It is easy, cost-efficient, and should come close to meeting your investment objectives.
If you still want to ultimately invest in 30 individual stocks, not a problem. Just invest in the funds until you have a critical mass, say $300,000, then sell the funds and purchase $10,000 each of the individual companies.
DCA as a No-Brainer
I shall discuss some pitfalls of DCA in a subsequent post. For now I shall simply say that DCA should not be a blind strategy.
If you are DCA in a fund or ETF that is well-diversified, then less work is required to invest.
I did not say no work, just less. That is because you are investing in a low-cost, well diversified portfolio that seeks to match the market returns. You are more concerned about the overall market, how closely the fund tracks that market, and the cost structure of the fund. You are less concerned with the daily happenings of each individual asset within the fund’s holdings.
If you are DCA in individual shares or non-diversified investments, you need to constantly monitor your investment’s potential. How is each asset performing against its peers, what are its future prospects, etc.
It is fine to average down your costs during a bear market. In fact, that is an advantage of DCA. You can get more bang for your buck during short-term down slides.
But it is completely another thing to be continuously investing in a bad asset. One whose price is falling for fundamental and permanent reasons, not just due to general volatility.
With individual assets, you need to constantly assess whether you are buying at a sale price or whether you are investing in a soon-to-be bankrupt business.
Never blindly DCA.
If you do, you may end up throwing good money after bad with some of your investments.
DCA promotes better investing consistency than a lump sum approach for those without ready cash reserves.
While DCA can work with individual assets, it works best when investing in diversified investments such as funds and ETFs. It also is preferable to use DCA in situations where where transaction costs are low.
The stronger consistency of DCA should improve the odds of achieving one’s investment objectives versus a less structured style. So consistency should be striven for when investing for the long run.
A close relation to consistency in investing is discipline.
We will look at that next time.