How to build your portfolio using dollar-cost averaging

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. 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.

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 and then plunge? Or do you apply, say, five years of dollar-cost averaging? We favour the last course of action and advise investing in stages.

Invest windfalls by dollar-cost averaging

If you come into a large sum of money, such as an inheritance or an early-retirement package, we’d advise you 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 more real bargains emerge in 2015. But if you’re prudent, you’ll remember to stick with the time-proven dollar-cost averaging approach.

Our view is that the stock market is now more sensitive to interest rates than many investors realize. The strong bull market since March, 2009, was largely fuelled by emergency-low interest rates. We expect interest rates to remain relatively-low for an extended period. But at some point, central banks are likely to raise interest rates. This is likely to happen first in the United States or the United Kingdom, where economic growth is higher and strengthening. When interest rates rise, all stocks are going to suffer.

If you invest regularly, keep it up. But stick mainly with high-quality, dividend-paying 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 and raise their dividends.

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

Most investors agree on the importance of sound portfolio fundamentals, including limiting how many stocks you own. Of course, this limit varies from investor to investor. Generally, if you buy too few stocks, you run the risk of a major setback if just one of them disappoints. On the other hand, if you buy too many stocks, a surge by one will have little impact on your portfolio. Many highly-successful investors had a few “home run” stocks that raised their overall returns.

More importantly, you may have trouble keeping track of them. We’ve found many investors over-estimate their ability to keep track of their holdings. When stocks rise quickly, many investors watch their stocks closely, in some cases several times a day. Trouble is, when the market suffers a setback, these investors find it painful to see stock prices, and their paper wealth, drop and are likely to ignore their portfolio and unknowingly lose track of their stocks.

It’s for these reasons we advise that each of your investments account for four to five per cent of your holdings. That way your portfolio will contain between 20 and 25 stocks. To keep between four and up to 10 per cent in each stock, you should consider rebalancing your portfolio from time to time. That is, sell stocks that account for over 10 per cent of your portfolio and buy stocks that account for four to five per cent of the money you invest in stocks.

 

The MoneyLetter, MPL Communications Inc.
133 Richmond St. W., Toronto, On, M5H 3M8, 1-800-804-8846