Foolish Four Portfolio
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Dollar cost averaging, DRIPs, and periodic investments
ALEXANDRIA, VA (Oct. 7, 1999) -- Can dollar cost averaging (DCA), dividend reinvestment plans (DRIPs), or periodic electronic fund transfers (EFTs) to your brokerage account be used with a Foolish Four portfolio?
Answers: Sort of, maybe, and with some difficulty, but not necessarily in that order.
There are many, many excellent reasons to invest smaller sums of money frequently. None of them works particularly well with the Foolish Four's plans, but it's possible to shoehorn them into working if you try. Let's look at them one at a time.
Dollar cost averaging. I'm not really crazy about this technique as it is usually presented. The bit about how you reduce your average cost per share by buying more shares when the price is low because you are investing the same amount every month (quarter, year, etc.) doesn't hold up well when you look at it statistically. The problem is that, over time, the market goes up more often than it goes down. So if you hold on to your money in order to dollar cost average, you are likely to be paying a higher average price per share than a lower one.
I'm not suggesting that anyone take their entire life savings out of bonds and plunk it into the market the day before they retire. But the odds do show that you will come out ahead that way more often than not, so feeling good about getting a better price by DCA is silly to me.
What I do like about DCA is that the technique is reassuring. Lots of people who are simply terrified of dropping thousands of dollars into the market at once can live with the idea of easing into the market over time. If that's what it takes to get them into the market, good on it, as they say Down Under. Also, if you have a lot to lose, it makes sense to protect yourself from the possibility of a major correction right after you switch from bonds to stocks by spreading out the transition.
Dividend reinvestment plans are a wonderful way to invest for those who may not have a big chunk of change sitting around. They can provide the discipline of investing whatever one can afford on a monthly basis. (You have to really like paper work, though!) We Fools like DRIPs so much that we started a portfolio to demonstrate how they work. But it's not this portfolio.
For all the good things DRIPs have going for them, they are not fast. It can easily take four to eight weeks to set one up. So you might pick your Foolish Four stocks today, start the paperwork tomorrow, and actually buy your first shares of stock two months later, when those stocks aren't even on the Foolish Four list any more.
An alternative method would be to use a discount broker to buy the stocks immediately, then transfer the shares to the company's DRIP plan. Your dividends will be automatically reinvested in the company stock, which is good, and you can buy more stock without paying a broker, which is good as long as the stock is still on the Foolish Four list. Then renewal time comes. Gotta sell those shares and invest in another company. You gotta really like paperwork.
So, yes, you can do it, and some people do. In fact, some have opened DRIP accounts at every Dow company that offers them so that they can be ready to make their Foolish Four investments quickly.
But DRIPs are designed to encourage long-term loyalty to a company. They are not designed to facilitate annual buys and sells. In most cases that works in your favor (provided you pick a good company to be loyal to), but if you want to use the Foolish Four strategy, a discount broker is far, far more efficient. Some will even reinvest your dividends for you for free.
Automatic monthly (or quarterly) investing via EFT or via checkbook is another wonderful technique. Almost any broker will let you set up a plan to transfer money from your bank account to your brokerage account. Again, there are many, many benefits to setting up a plan like this. The most important one is that you are "paying yourself" first by getting that cash somewhat out of reach. But once it gets to your broker, can you pop it into the Foolish Four?
This one works a bit better than DRIPs for small periodic investments and makes more sense theoretically than DCA. DCA is often used to justify these kind of automatic plans, but I think it's more logical to simply assume you are investing your cash as soon as you can rather than dollar cost averaging. Those frequent deposits require a bit of adjustment in your Foolish Four strategy though.
So, if for any reason, you want to work frequent periodic contributions into a Foolish Four strategy, here is how I would do it.
First, figure out your minimum investment amount by dividing your broker's commission by 0.02 (e.g., $10/.02 = $500). This tells you what amount your commission is 2% of. If the answer is more than you are saving each month, plan to invest every two, three, four, or so months instead. (In the case of DRIPs, use the cost to set up the DRIP instead of the commission and apply it to the initial purchase amount only.)
But what do you invest in? The #2 stock on that list over there to the right. That's the top Foolish Four stock and traditionally it has performed best. If you have more money to invest or if you already own it, move down the list to #3 or #4.
Now, here's the key. Don't even think about selling that stock one year later. Instead, plan to hold it until the end of next year and roll it into a main Foolish Four portfolio at that time.
The idea is to start your stocks throughout the year, but to renew them only during December (but not this December). There are two reasons: First, after a few years you will go nuts trying to track all those stocks. More important, though, our research shows that, over time, returns are significantly higher for portfolios renewed in December or January and barely higher than the market for summer portfolios. Late December seems to be the optimal time to renew. The last thing you want is a series of 12 portfolios renewing annually throughout the year.
Now, of course, those are long-term averages we are talking about. A December portfolio won't be best every year. And we are talking about past returns, the average over the last 38 years. There's no guarantee that this pattern will continue. But for now, it makes sense to keep the bulk of your Foolish Four portfolio on a December-to-December cycle.
I'd better explain why I said "not this December." There are two reasons. If your investments are subject to capital gains taxes, you need to make sure you hold for at least a year and a day in order to qualify for the lower long-term rates. But even in a retirement account, holding for longer than a year is usually better than holding for shorter periods. Again, I am speaking statistically, and if, come December, your stocks are way up and you want to trade them in on a new batch, fine. But plan to hold them for the longer term. Shorter holding periods are very iffy.
Then again, you could just stash the cash in a money market account until December. That's what our backtest assumed and it did OK.
Fool on and prosper!