Quality and Dollar Cost Averaging

On 03/21/2011, in Investment Strategies, by Jordan Wilson

One final comment on Dollar Cost Averaging (DCA).

For DCA to work, you need to invest in quality assets.

I have mentioned this in prior DCA posts, but I want to emphasize it separately. 

Although some investors use DCA as a blind investment strategy, do not follow their lead.

Long-Term Quality, Quality, Quality

Did I say quality?

You need to identify high quality assets with above average long-term growth potential.

Then, during down cycles, you will be buying at sale prices.

But if you invest in poor quality assets, falling prices may not indicate a sale. Instead, they may be a harbinger of things to come. Things such as permanent price reductions, delistings, bankruptcies, etc. Things investors strive to avoid.

DCA is a good strategy for quality assets.

For inferior investments, it may lead you to throw good money after bad.

Quality – An Elusive Concept

“What am I reading this for?” I hear you ask. “I need to learn how to identify quality!”

Yes, I realize that if you knew how to separate the investment wheat from the chaff, you would already be a millionaire and have no need for personal wealth management blogs.

And therein lies maybe the number one problem in investing.

How to find quality assets and avoid the dross.

Not an easy thing to do for a variety of reasons, including: efficiency of financial markets; sheer number of analysts and investment researchers; expertise of the average investor versus a trained professional; differing access to information between amateurs and professionals; time available for the average investor to research.

For DCA, I suggest you stick with ready-made diversified assets that provide some long-term safeguards against asset specific risks. Mutual fund and exchange traded funds are my favourite options for cost-effective diversification.

Yes, each fund will have a few dogs. But they will also have a few superstars and a host of average performers which will nicely offset the losers.

If you already have accumulated a fair bit of wealth, you can create your own diversified portfolio. There are plenty of solid companies or assets out there that can fit nicely into a portfolio. But you will need to do more research and monitoring than with investing in funds.

And if building your own portfolio, remember our conversations on portfolio diversification and asset correlations. Not all assets mesh together in the same way.

Quality – An Ever Changing Concept

Approximately 100 years ago, I could have given you the name of a strong industry in which to invest. No major competition, long history of earnings, no current threats in sight. Sounds to me like a quality industry to invest in. And it was.

Then along came Benz, Daimler, Ford, etal., and the horse and buggy industry went the way of, well, the horse and buggy.

In my own era, I remember the Beta versus VHS video tape battles. Beta was deemed superior in quality, but VHS won the war. Then came along dvds and VHS video tapes joined the 8-Track on the scrapheap. Or what about the revolutionary Sony Walkman? A great money maker for Sony. In today’s age of the iPod, not so much now.

The world is not static. It is constantly in flux.

What was a quality product today, may not be tomorrow.

What was an inferior company today may catch fire tomorrow.

For example, in 19xx, ABC developed a new product. Not a success. The first quarter of the next year ABC posted its first quarterly loss and laid off 20% of their employees. In April, the co-founder of ABC was removed from all operational involvement with ABC. In the year after the co-founder’s departure, ABC traded in the USD 15-20 range. That compared quite unfavourably to the USD 25-30 range it had traded at since it opened in September 19xx.

Not a particularly good company to invest in. Corporate losses, large layoffs, founder ousted, share price down 33-50%. Ugly.

Now that is a dog to avoid.

But what if I add three additional bits of information?

The years in question where late 1984 and early 1985. The company was Apple. And the co-founder was Steve Jobs.

Today Apple is trading in the USD 350 range. Had you invested USD 1600 on June 3, 1985 at USD 16.00 per share, you would have acquired 100 shares.

Adjusted for stock splits and ignoring cash dividends paid, your USD 1000 investment would have grown to 874 shares worth over USD 300,000 now.

Not a bad return on an inferior company.

And yes, sadly for the majority of investors out there who missed the boat, that is a true story.

Unless you have the special skills to find the next Apple, hedge your bets. Invest in a variety of assets with funds. You may not get all the superstars, but you will avoid the dogs.

Quality Must Be Continually Monitored

As quality of an asset can change over time, you must review your portfolio on a periodic and consistent basis.

As an aside, the perceived quality can also change over time. Look at the major fluctuations in value of gold, residential real estate, oil over the last 10-20 years. Has the quality of the asset risen or fallen at various points of time? Or has the perception of value changed during those periods based on other factors?

Often perception becomes reality in the short-term, whether it makes sense or not. But over the longer run, the facts usually shine through.

We will consider portfolio monitoring later in detail.

Both for actual quality shifts as well as perceived changes.

For now, know that you must monitor your holdings to ensure that you do own superior products with long-term upside potential.

Under-performing assets must be assessed as to whether the poor results are temporary or permanent. If permanent, changes must must be made. If temporary or due to incorrect perceptions, perhaps there is the opportunity to increase your position at a discounted price.

Again, a little easier said than done.

Hopefully though, I can pass on some tips to improve your assessments.

What To Do About Poor Quality

If investing in individual, non-diversified assets, you will likely acquire your share of under-performing investments. No one gets them all right.

You also run a risk with funds, especially if they are actively managed or in specialized sectors. But if you are trying to match a specific market using low cost index funds that adequately track the market, your risk of under-performing the benchmark is small.

Yet another reason to like passive investing in low-cost index funds.

There are tactics to deal with your losers. We will look at these down the road. Stop-loss orders, setting downside limits for reviews are two popular approaches.

I think that is all I want to say about DCA for the time being.

Next we will start to look at useful acquisition tactics for long-term success.

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