Dollar-cost Averaging Powers Dividend Farming

Dollar-cost averaging is an integral part of DividendFarming.  It’s a powerful method of growing a great financial crop.  The best part; it’s simple and automatic.

In a nutshell, dollar-cost averaging means contributing an amount of money to your investment portfolio to purchase stock on a monthly basis.  You could also do so quarterly, but monthly is advantageous due to the increased number of compounding periods.  The more the merrier, but I digress.  As an example, you might purchase $100 worth of stock each month and do so irrespective of whether the stock’s price has increased or decreased.

Courtesy of JP Morgan

With dollar-cost averaging you may purchase a few shares at high prices, but you are also likely to purchase more shares at lower prices.  The table below demonstrates the principle using the $100 example mentioned previously.

Month	Share Price	Shares Purchased
January	$25	4
February	$28	3.5
March	$27	3.7
April	$23	4.3
May	$20	5
June	$22	4.5
TOTAL		25

You will have purchased anywhere from 3.5 to 5 shares per month with your $100 investment as long as you were disciplined about putting money into your brokerage account and making the purchase. 

Brokerage Fees and Partial Shares

Realistically, if you were making the purchases with contributions to your account, the stock purchase figures would be lower because you would have paid a brokerage fee each time you made a purchase.  If a broker charged you $5 for each trade, you would be investing only $95 per month to buy stock.  Consequently, the quantity of stock you buy each month would be lower than shown. 

It should also be noted you can’t buy partial shares this way.  This means another portion of your $100 would be unavailable to use for purchases each month.  This money could be held in the account and used to supplement your purchase the following month, but you still miss the full effect of dollar-cost averaging.  The next table offers clarity.

Month	Share Price	Commission Fee	Funds Available	Shares Purchased	Balance
January	$25	$5	$95	3.0	$20
February	$28	$5	$95	3.0	$6
March	$27	$5	$95	3.0	$9
April	$23	$5	$95	4.0	$3
May	$20	$5	$95	4.0	$10
June	$22	$5	$95	4.0	$7
TOTAL				21	$56

In this example, which is more realistic, you would purchase only 21 shares during the same 6-month period versus the previous case.  You would contribute $30 to your broker for the privilege of making the purchases.  An additional $56 of your $600 in investment funds accumulated in the account because you can’t purchase partial shares. 

Based on the purchase prices shown, you would have to accumulate the leftover funds for about 3 months before you could use them to purchase an additional share of stock.  You effectively lost $86 ($30 + $56) or 14.3% of your investment to the broker or the opportunity-cost associated with not being fully invested each month.

Ok, if you lose a large chunk of your investment funds in the dollar-cost averaging example shown, how can that be beneficial to you as a dividend farmer?  When farming dividend stocks, the dividend payments can be accepted into your brokerage account as cash and reinvested in additional dividend stock.  Managing your dividends this way results in the kind of attrition highlighted in the second table.

DRIP Strength

However, if you have your dividend payments automatically reinvested in the companies paying them, you avoid the brokerage fees and you’re allowed to purchase partial shares.  When you receive $600 worth of dividends and reinvest them in a DRIP, you put the full $600 to work for you, compounding all the way, increasing your crop yield.  

This is the true power of dividend reinvestments.  Additionally, you’re assured of automatic contributions to your portfolio each month.  Efficient, disciplined investing maximizing your ability to grow a healthy dividend crop.  Who doesn’t like that?

   

The thoughts and opinions expressed here are those of the author, who is not a financial professional.  Opinions expressed here should not be considered investment advice.  They are presented for discussion and entertainment purposes only.  For specific investment advice or assistance, please contact a registered investment advisor, licensed broker, or other financial professional.

5.5 Reasons Dividend Payers Beat Index Mutual Funds & ETFs

Index?  Mutual?  Dividend CCC!

Over the past couple months I’ve covered a host of reasons I think investing in strong dividend paying companies is better than parking money in real estate, precious metals and collectibles, non-dividend stocks, annuities, and target date mutual funds.  Therefore, I thought I’d tackle the reasons dividend stock investing is superior to index mutual funds or ETFs.  I’ve had a lot of coffee today and it’s probably a good thing, so here we go.

1) Compound growth is more reliable with dividend stocks than it is with index mutual funds and ETFs in general.  When individually held dividend stocks pay out their dividends, those dividends turn directly into additional shares of the company, assuming you’re enrolled in a Dividend Reinvestment Plan (DRIP).  Many, but not all, index funds and ETFs will retain dividends paid, increasing the Net Asset Value (NAV) rather than turning those dividends into additional shares of the fund for you.  I hold a couple such index funds in a 529 plan for my kids and a 401k so I’m well aware of this fact.  I don’t have much choice in either case.  Otherwise, neither would be in my portfolio.  NAV can fluctuate up and down given the market movement of the stocks it holds, irrespective of dividend payments.  In comparison, directly held dividend payers don’t subtract shares from your bucket unless you sell them.

2) Management fees erode your returns.  When participating in the DRIPs of dividend paying companies, or automatically reinvesting dividends from stock held in your brokerage, you don’t suffer the penalty of management fees.  The same cannot be said of index funds or ETFs.  This is particularly true if you’ve blundered into a managed index or ETF in which case your fees can be as high as a half-percent per year.  That may not sound like much, but once your portfolio reaches $100,000, you’ll lose $500 every year.  Those losses add quickly, particularly when you factor in the power of compound growth foregone.

3) Visibility and manageability of your holdings is much better with a select portfolio of dividend payers.  An index fund or ETF attempts to hold the same companies, in the same proportion, as found in the index it tracks.  Consequently you could own thousands of firms, most of which you’ll care little about – if you know about them at all.  To find out what you own in an index fund you have to sort through multiple pages and potentially thousands of lines of the index fund prospectus to know what’s in your basket.  That’s too much for most amateurs to manage in which case you’ll pay fees for a manager.  Brokerages like this.  See item #2 regarding management fees.

4) Investment diversity is frequently argued as a simple, brilliant form of risk mitigation.  The financial industry has taken the argument to the nth degree by selling the proposition that a fund of hundreds or thousands of companies offers greater diversification i.e., less risk, than a smaller grouping of individually held dividend paying stocks.  But is this true?  I can get considerable diversity or risk mitigation with 20-30 holdings in a well-chosen selection of dividend payers.  Adding hundreds of additional companies doesn’t reduce my risk much beyond that smaller holding – particularly if all those holdings are wrapped in a single package delivered by one financial institution.  In a future post, I’ll take a brief look at the probability underpinning the maxim of investment diversification. 

An index fund allows you to hold many, many companies at once providing the touted investment diversification.  However, I would argue that a vast array of companies is not necessarily better.  Warren Buffett agrees.  Or better, I’m of the same opinion as Warren, who said “diversification is protection against ignorance. It makes little sense if you know what you are doing."  The theory is most investors don’t know a post hole from their pie hole and should buy a huge basket of everything to limit risk rather than learning something about a few things and sticking with what they actually know.  The argument is great for the croupier class taking tine pieces of considerable investment activity via small management fees tacked onto index funds and ETFs.

5) Selective quality with individually held dividend stocks is much great than it is with an index fund or ETF.  Consider the estate sale in which a box of unknown stuff is auctioned off with little or no inspection by the bidders.  Bidders are attempting to buy the box at the lowest possible price hoping they’ll find a diamond among the rubbish they know they’ll get otherwise.  When you buy an index fund or ETF, it’s the same principle.  You’re buying thousands of companies in one fell swoop hoping the handful of gems more than offset the dregs and millstones you’ll invariably get.  It's less risky to pick and choose what you're putting your money into than throwing it over the wall and hoping for the best.

5.5) Additional thoughts:  Advocates of index funds and ETFs argue that diversification for small investors is easier with an index fund than individually held stocks.  This is true if you have only a couple hundred bucks to invest.  Once your investment basket has climbed above a few thousand dollars, I’m not sure that argument still holds.

A second argument is that index funds allow people to invest in with little risk, but complete ignorance.  Investors don’t have to read, research, or even think to participate safely in the market, or so goes the story.  I’m not sure this is a stellar idea to propagate but it’s a thing none-the-less.  It's better to put in a bit of effort when participating than diving in completely unaware.  Contrary to the old axiom, ignorance is not always bliss, particularly when investing for your future.

The thoughts and opinions expressed here are those of the author, who is not a financial professional, and therefore should not be considered as investment advice.  This information is presented for education and entertainment purposes only.  For specific investment advice or assistance, please contact a registered investment advisor, licensed broker, or other financial professional.