We’ve always held a high opinion of dollar-cost averaging. That’s because we’ve often seen this investment strategy richly reward those who follow it.
To dollar-cost average, of course, you invest equal amounts of money into the stock market at regular intervals. It’s best to stick to high-quality, blue chip stocks like our ‘Very Conservative’ or ‘Conservative’ Key stocks. You invest regardless of whether the stock market is rising or falling, instead of trying to time the market. This way, you buy more shares when prices are low and fewer when prices are high.
This is a sound and ultimately profitable strategy if you’re regularly investing a stream of income. It takes note of the fact that market peaks and valleys are notoriously hard to recognize as they occur, even if they seem all-too-obvious a few years later.
What about investing lump sums?
Are things different, however, when you invest a lump sum, rather than a stream of income? Do you plunge in now? Or do you wait for share prices to fall even further, then plunge? Or do you apply, say, five years of dollar-cost averaging? We favor the last course of action and advise investing in stages.
Our view is that the stock market is more sensitive to interest rates than many investors realize. The rising markets since the last financial crisis were partly fueled by falling interest rates. Yes, lower rates have done little for stocks in 2020. But that’s because of a loss of confidence due to the stock market setback, the failure of major companies, a coming global recession, excessive debt and so on. Still, the fact remains that the level of interest rates matters. The next direction of interest rates is likely up.
Over the next few years, heavy government borrowing, a recovering world economy and rising inflation could push up interest rates. The Bank of Canada will raise rates if inflation jumps. When interest rates rise sharply, stocks can suffer.
If you invest regularly, keep it up. But stick mainly with high-quality stocks. Choose companies in well-established businesses that trade at reasonable multiples of profit. Select only those that are taking concrete steps to improve their long-term earnings.
If you come into a large sum of money, such as an inheritance or an early-retirement package, we’d advise you plan to average in to the stock market over five years or so. Of course, you can always speed up your buying if stocks resume their fall and more real bargains emerge this year and in 2021. But if you’re prudent, you’ll remember to stick with the time-proven dollar-cost averaging approach.
You should also balance and diversify your holdings over the five main economic sectors: finance, utilities, consumer products and services, manufacturing and resources. And finally, you should set limits on how many stocks you own.
Remember to set limits
One thing most investors agree on after the market setback is the importance of sound portfolio fundamentals. This includes setting a limit on how many stocks you own. This limit varies from investor to investor, of course.
Generally, if you buy too few stocks, you run the risk of a major setback if just one of your choices proves to be a disappointment. If you buy too many stocks, on the other hand, a surge by one will have little impact on your portfolio. More important, you may have trouble keeping track of them. We’ve found many investors over-estimate their ability to keep track of their holdings during a rising market.
When stocks rise quickly, many investors watch their stocks closely, in some cases several times a day. This gives them the impression that they can closely follow many stocks. The trouble is, when the market suffers a big setback, these investors find it painful to see stock prices, and their paper wealth, drop. At this point, they’re likely to ignore their portfolio and unknowingly lose track of their stocks.
It’s for these reasons we advise that each of your stocks makes up about four or five per cent of your holdings. That way your portfolio will contain between 20 and 25 stocks. To keep four or five per cent in each stock, you should rebalance your portfolio from time to time. That is, sell stocks that account for far over five per cent of your portfolio and buy stocks that account for less than four per cent. Also, now’s a fine time to rebalance from bonds to stocks.
This is an edited version of an article that was originally published for subscribers in the April 24, 2020, issue of The Investment Reporter. You can profit from the award-winning advice subscribers receive regularly in The Investment Reporter.
The Investment Reporter, MPL Communications Inc.
133 Richmond St. W., Toronto, On, M5H 3M8, 1-800-804-8846