The Two Most Efficient Stock Buying Strategies

When it comes to investing your money in the market, there are two ways you can go about doing so. The first is to invest everything you have all at once, and the other is to divide your initial investment into smaller portions. The former method is referred to as lump-sum investing (LS) and the latter is called dollar-cost averaging (DCA).

We’ll say this right off the bat: Lump-sum investing is always better. However, there are many ways in which investors complicate the process and often end up confusing LS for DCA. Let’s begin by clearly illustrating how LS and DCA work.

Lump Sum or Dollar Cost Averaging?

Let’s say you have $10,000 to invest. Should you invest all of it at once or should you break it up into smaller investments of $1,000 each and invest these over a period of 10 months? The former method is LS and the latter is DCA.

DCA is not the following: Let’s say you receive a steady cash flow of $1,000 per month through your savings after paying for your living expenses. You then invest $1,000 into the market every month like clockwork. This is not DCA. In fact, this is LS investing. We wish to highlight this because many people confuse this for being DCA.

The primary difference between LS and DCA is that with the latter, you’re not fully invested in the market. You’re setting aside some money as cash at all times. The reasoning behind doing this is that by breaking your investment into smaller parts, you’re reducing your risk over a longer period.

For example, if the market declines between months two and six in our previous example, your $1,000 investments over this time will result in you buying stocks at lower prices. This, in turn, reduces your average purchase price, and therefore, you increase the potential size of your capital gains whenever the stock moves upwards.

This works in theory, but it ignores two practical aspects of investing. First, it assumes that the investor practicing the LS method will never invest their money back into the market ever again. Second, it assumes that markets will fall over the short term and that the investor can accurately predict how long they’ll fall for.

In other words: If you invest your $10,000 all at once. This is hardly going to be your only stock investment over your lifetime. Who’s to say that when you decide to enter the market once again, the market prices will not be low? There’s no way to predict this. The DCA reasoning assumes that by investing small amounts over time, you’ll reduce your risk.

But what is the appropriate timeline for you to divide your investments into? Should you invest $10,000 over a year? Two years? A decade? This is again, impossible to predict. However, all of this pales in comparison to the real disadvantage of DCA, which is opportunity cost.

Missing Out on Gains

Let’s say you invest $10,000 fully into the market. We’ve already established that the stock market rises by an average of seven percent over the long term. Let’s also assume that your investment horizon is 20 years. At the end of this time, your investment will have grown to $38,696.

Now, let’s say you practice extreme DCA and divide your $10,000 investment into equal sums and invest it every year for 20 years. This means you’ll invest $500 every year. We don’t need to run the numbers to prove that this is a losing strategy. With lesser money invested, you’re going to be losing out on long term appreciation of capital as well as becoming a victim to inflation. This is where DCA falls horribly short.

You might argue that we’re using the assumed return rate of 7% and aren’t taking into consideration the fact that the average purchase price might decrease thanks to market declines during this 20 year period. A study that compared the two investing methods using market data from 1960 until 2019 indicates that DCA underperforms lump-sum investing 80% of the time over this period (Maggiulli, 2020).

We must note that DCA outperforms LS during market slumps, as you might expect. However, once the market recovers, LS begins outperforming DCA dramatically and the deficit in performance is erased quickly.

All of this means that instead of asking yourself which method is better when it comes to investing. Focus on having as much of your money invested for as long as possible. This is how returns are earned. This is how you can access greater compounding power. As you know, compounding becomes more powerful the longer you apply it.

Therefore, if you have a large sum of money to invest right now, invest all of it in fairly valued companies. We must emphasize that this doesn’t mean putting everything into a single company. You must diversify your investments and use ETFs or mutual funds if necessary. Focus on investing whatever you can, whenever you can. If you have a steady cash flow that allows you to invest money in the market at regular intervals, then do so. Leaving your money sitting on the sidelines doing nothing is the worst possible thing you can do with it.

DRIP

DRIP stands for dividend reinvestment plan. This is a great way to automate your investing and use the power of dividends to boost your returns. They’re available on pretty much every dividend paying single, and you’re better off opting for them most of the time.

Here’s how a DRIP works: When you receive a dividend payment, you can choose to receive it in cash or reinvest that money to buy even more of the stock via a DRIP. By choosing the DRIP option, your broker automatically buys the equivalent amount of shares of stock, and your stock holding increases.

This, in turn, will increase the amount of dividends you’ll earn the next time and by reinvesting that sum, you’ll increase your stock holding, and this will further increase your dividend and so on.

For example, let’s say you own a single share of a stock for $100. This stock pays you a dividend of $2 and you choose the DRIP option. Your broker will buy a fraction of share that is worth $2. Your total number of shares will increase to 1.02 after this. Fractional shares can be bought only via DRIPs. If you receive the dividend as cash and then try to purchase $2 worth of a $100 stock, you won’t be able to buy it.

Now that the size of your holding is 1.02 shares, your dividend payment will be slightly greater than before. Assuming the stock still pays $2 per share in dividends, you’ll now receive $2.04. If you reinvest this, you’ll now own 1.04 shares (up from 1.02). Thus, your dividend payment–as well as your stock holding–increased in number.

The best part about a DRIP is that there are no costs associated with buying these fractional shares. Thus, you get more bang for your buck. Reducing costs has a dramatic effect on overall returns, thanks to compounding. By not paying costs, you’ll allow more of your money to compound and are thus capturing greater growth.

The other great aspect of DRIPs is that some companies offer discounts on purchase prices if you choose to invest via a DRIP. Often you can expect a discount of up to 10%. Over time, this will massively boost your capital gains as well as your dividend payment amounts since you’ll be able to buy more shares.

In our previous example, additional shares of 0.02 might seem paltry but understand that this assumes prices remain stable. If stock prices decrease, you’ll be buying even more shares. When the upswing happens, your gains will proportionally increase. Also, DRIPs work best over time, and this is perfectly in line with the investment principles we outlined previously.

There are a couple of disadvantages you must be aware of when it comes to DRIPs. The first one is that you’re not going to be in total control of your money. As long as you’ve chosen to opt for the DRIP, you’re not going to receive the cash into your account. It’ll be reinvested all by itself, and this will make some people uncomfortable. If you want to implement a set and forget investment strategy, though, this is the best option for you to choose.

The biggest disadvantage has to do with taxes, but even this isn’t as bad as it sounds. Since you won’t be receiving money into your account, you might be tempted to think that you don’t owe any taxes. However, you will still have to pay taxes on your dividend amounts, and being unaware of this can lead to some nasty surprises during tax time.

Just remember that even if you reinvest the entire sum automatically, you’re still liable to pay taxes on your dividend income.

Read Books to Learn The Right Investment Mindset

A large part of successful investing is about Mindset. So I read many mindset books.

Recently, I read Rich Dad Poor Dad and found it quite interesting.

Through autobiography and personal experience, Rich Dad Poor Dad explores the steps to becoming financially independent and wealthy. 

The writing style and framework of this book are narratives. This book focuses primarily on anecdotes with nuggets of supposed wisdom, not technical insight or investment math.

He compares the lessons he learned from his biological father (an intelligent, but financially inept father) with the lessons that he learned from his friend’s father (an uneducated, but smart and wealthy father).

It weaves through Kiyosaki’s life as he learns from his rich father and rejects advice from his poor father (thereby eclipsing typical working-class mindsets).

Some of the concepts in this book are, however, questionable. Read my Rich Dad Poor Dad review to learn more about my insights about the book.

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