Client situation
Dexter is a 28-year-old researcher and is one month away from the end of his three-year contract with the government. He is confident that his employment will be renewed at his current salary of $7,500 plus an end of contract after-tax gratuity of $54,000. Dexter is an only child and lives in a three-bedroom apartment downstairs of his father’s house.
He decided that he would continue living there even after he starts a family in 10 year’s time. Dexter used his previous gratuity and all of his savings to purchase a car but wants to rebuild his portfolio by setting aside his lump sum and 20 per cent of his monthly salary.
Two of his colleagues at work are encouraging him to invest in the stock market because of his age and limited commitments. However, their opinions diverge on what strategy to employ. Mike tells him to pick a good stock and invest his entire gratuity and monthly savings in that company. Steve suggests he should not put all of his eggs in one basket but split up his lump sum across three stocks plus invest in them monthly.
Dexter knows that in the next 10 years he could have a sizeable sum from investing in the stock market but he is cautious and confused as to which advice to follow and is inclined to just leave the money in the bank as he did before.
Nick’s assessment and advice
Dexter’s risk profile
On the surface, Dexter appears to be a conservative invester but this might be purely as a result of his relative inexperience in the stock market and investing in general. This instinct protects him from losing his hard earned cash from a poor decision. On the other hand, he recognises the merit of taking a little more risk at least over the long haul.
Dexter is both young and has a specific 10-year investing time horizon. This means he has a lot of life ahead of him to recover from any investment losses and during his investing time frame he could see a smoothing out of the short-term variability of the stock market. Additionally, over the next 10 years as inflation pushes up the costs of living and the values of everything, revenues and profits of companies should keep pace.
Liquidity and asset allocation
Another factor that contributes to Dexter’s apparent risk aversion is the fact that he used all of his cash resources to purchase a car; diverting his entire upcoming gratuity and monthly savings solely to the stock market takes away his financial cushion in case something unexpected happens.
Ideally, he should have at least three to six months salary set-aside in a relatively safe and accessible instrument. These include a regular bank account, a money market account or a credit union deposit account. Any money outside of this he could consider investing.
Diversification, direct and indirect investing
Whilst Mike’s strategy of picking a good stock and putting all of Dexter’s money behind it may produce significant growth if the company does well; if the company does poorly it could erode much of his values and even wipe out his investment if that company should fail.
Steve’s strategy to split Dexter’s investment would spread the risk so that if one company does poorly he will not lose the entire portfolio. Of course this means that the underperforming companies could dilute the returns of the good performers.
Directly investing in the stock market every month for the next 10 years could be a hassle as each time Dexter has to place a purchase order with his stockbroker and wait to see what happens. One way to get around this challenge is to consider investing in a stock based mutual fund whereby he simply has to set up a standing order from his bank account to his mutual fund account. The mutual fund company does all of the work and the risk is spread over many more companies.
The downside with mutual funds is where the individual stock investor benefits directly from dividends and share price increases; the returns from a stock mutual fund are diluted, as the mutual fund company has to cover its operating expenses. Some of these expenses are taken out from the funds under management and/or at the point of investing (bid /offer spreads). These costs must be compared with what the stockbroker charges when placing each purchase order.
Dollar cost averaging versus lump sum investing
Share prices and stock mutual fund unit prices fluctuate, sometimes daily. It is quite possible that Dexter could invest a lump sum of money in a share today and the price could fall tomorrow. He then has to wait it out to see if the price recovers. If he bought when the price was at an all-time high and then it falls and never recovers, he has to decide if to hold or cut his losses and move on. Conversely, if he buys at an all-time low then he can rest easy because is will always be “in the money”.
The key is: buy low and sell high, but the challenge remains that there is no way to really know if tomorrow’s prices would be higher or lower than today’s. For this reason Dexter should systematically invest his $1,500 (20% x $7,500) every month and take advantage of these fluctuations in prices.
When prices fall he would buy more units or shares—averaging down his overall cost per share or unit—when prices recover he has a greater number of shares to benefit from the increase. What he can do with the remainder of his lump sum of $31,500 is invest tranches of it periodically when he sees his unit prices falling; thus giving him the extra boost by buying more for less.
(Details were modified to protect client’s identity)
Nicholas Dean (Cer-Fa) is a financial coach and mentor who is the managing director of the Financial Coaching Centre. He can be contacted at:
nickadvice@gmail.comwww.FinancialCoachingCentre.com