A third reason I think Dollar Cost Averaging (DCA) is a useful tool is that it is great for building a diversified portfolio over time.
That is not to say that one cannot build a diversified portfolio through lump sum investing. However, I believe that DCA can make the process easier and more consistent for investors, especially those with limited resources.
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 $1000 to invest. Instead of buying 100 shares of ABC company at $10 per share, you are able to 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, $1000 will not buy you much, if anything.
However, your $1000 will get you about 33 shares of the iShares FTSE EPRA/NAREIT Developed Real Estate ex-U.S. Index Fund (symbol: IFGL). According to the iShare fact sheet, this ETF tracks the “stock performance of companies engaged in ownership, disposure, and development of the Canadian, European, and Asian real estate markets.”
The ETF has 176 different holdings (top 10 investments comprise 34% of total holdings). It invests in a variety of countries and real estate sectors, including: holding and development; retail; industrial and office; residential; hotels and lodging.
For a relatively small cost (there is an annual total expense ratio of 0.48%) you get substantial diversification across geographic regions, real estate sectors, and individual holdings. Not bad for your $1000.
As an aside, note that this iShares ETF invests indirectly in real estate. It acquires companies operating in the real estate sector and in Real Estate Investment Trusts (REITs). Many ETFs and real estate mutual funds do not directly invest in real estate. REITs, and certain speciality funds, generally do invest directly in real estate or mortgages on property. So if you want more direct investments in real estate, consider REITs. As with any investment, there are a variety of issues to consider with real estate. We will look at many of them in due course.
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 many companies whose stocks have very high valuations.
For an investor with little money to invest periodically, that can pose a problem.
For example, if you wish to purchase 1 common share of Apple (AAPL), you currently need at least USD 360 to buy one share. If you only have USD 300, no Apple for you.
But if you invest that $300 in the Vanguard Growth Index (VIGRX) mutual fund, you will acquire between 9 and 10 units. And each unit would contain 4.7% of its holdings in Apple.
Or if you want a higher concentration of Apple in your investment, consider the PowerShares QQQ (QQQQ) ETF. Your $300 currently buys about 5 units of QQQQ. Apple shares make up 20% of its fund holdings.
Although you may not have enough money to buy 1 share of Apple, you can get decent exposure to the stock through a fund.
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 now 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.
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.
For example, E*TRADE offers over 7600 mutual funds. About 1100 of these have waived commissions. TD Ameritrade has “hundreds” of waived commission funds in their 13,000 plus offering. Scottrade waives fees on nearly 3000 of their 15,000 available mutual funds.
Shop Around for Best Rates on Mutual Fund Commissions
And for those funds that do require a commission to the broker, price competition has reduced fees substantially. 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.
E*TRADE charges a USD 19.99 transaction fee on no-load, non-broker assisted mutual fund trades. TD Ameritrade charges USD 49.99 (a little high). Scotttrade charges USD 17.00.
Watch the fine print when comparing fees. Often there are other charges hidden that need to be uncovered. Do not simply focus on the come-on prices.
And compare the offerings between brokers. USD 49.99 may seem too high at TD Ameritrade versus E*TRADE or Scottrade. But if you want to invest in mutual funds exclusive to TD, you might decide the cost is justified. Or perhaps TD’s other products and service costs offset their higher mutual fund commissions.
While pricing is better than in prior years, I suggest if you are investing small amounts to try and find no-transaction fee funds when buying through your broker. Otherwise avoid the fee by buying directly from the mutual fund.
Or buy similar investment style ETFs instead.
Many ETFs are available that nearly replicate many mutual funds. You might easily find an ETF that meets your needs, yet pay a lower transaction fee.
E*TRADE and TD Ameritrade charge USD 9.99 per transaction on internet trades for ETFs that are not part of their waived commission programs. Scottrade charges even less at USD 7.00. All are materially lower than their transaction fees on non-waived fee mutual funds.
And what about our real world examples above? We looked at the mutual fund, VIGRX, and the ETF, QQQQ. How do their costs compare?
VIGRX is no load mutual fund with a 0.28% total expense ratio. VIGRX does require an initial minimum purchase of $3000, but subsequent investments can be as low as $100. And purchases can be facilitated through direct debits.
With the QQQQ ETF, you may need to pay a brokerage commission on any purchases or sales (that said, some brokers may waive this ETF’s commission, check with your broker as each differs somewhat). However, the total expense ratio is only 0.20%.
So in these two cases, we see that it is no longer a big cost advantage for lump sum investing over DCA.
Small investors can easily build a diversified portfolio using DCA.
Use of mutual funds and ETFs allows 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 the broker’s commission. Consider funds with waived fees.
ETFs are also effective, but one must consider transaction costs. Broker commissions on ETFs are generally lower than for mutual funds, but they should still be monitored. There are also waived commission 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.