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 at regular intervals. It’s best to stick to high-quality stocks like our Very Conservative or Conservative Key stocks. You invest regardless of whether the market is rising or falling, instead of trying to time the market. This way, you buy more shares when prices are low and fewer shares 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 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, and then plunge in? 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 now more sensitive to interest rates than many investors realize. The strong bull market since the financial crisis of 2008 and 2009 has been partly fueled by falling interest rates. Indeed, some central banks implemented negative interest rates. Others turned to unconventional monetary tools, such as ‘quantitative easing’ (creating money and buying lots of bonds to reduce interest rates). With the U.S. now raising its benchmark rate, investors will rediscover that the level of interest rates matters.
In recent years, many homeowners in Canada have refinanced and expanded their consumer debt with variable-rate mortgages. Next year, a strengthening world economy and rising inflation could push up interest rates.
If you invest regularly, keep it up. But stick mainly to 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 to plan on averaging in to the stock market over five years or so. Of course, you can always speed up your buying if stocks fall and real bargains emerge this year. 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 and re-balance your portfolio
One thing most investors agree on these days 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 bull 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. Trouble is, when the market suffers a 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 investments should start out at four or five per cent of your holdings. That way your portfolio will contain between 20 and 25 stocks. To keep between four or five per cent in each stock, you should consider re-balancing your portfolio from time to time. That is, sell stocks that account for, say, 10 per cent or more of your portfolio and shift the proceeds to stocks that account for less than four per cent.
This is an edited version of an article that was originally published for subscribers in the April 21, 2017, 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.
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