Would you like a simple yet effective way
For a better life, here's a principle that will serve you well - Always pay yourself first when you get money. Don't spend all you make. Spending all you make is the financial plan of the poor. For happiness, you need a better plan.
That one action of paying yourself first can make all the difference in how your life turns out. It should be taught by every parent and in every school. Paying yourself first allows you to accumulate money to invest, and to then earn returns through compound interest.
So, let's say you have decided to pay yourself first. Now, let's go to the next step - Investing your savings. Did you know that the stock market has earned an average of over 10% over the years? (That's adjusted for inflation.) That being the case, perhaps you'll want to invest some of your money there, in the stock market.
Now, you wonder, with the variety of options for investing in the stock market, how and where to put your money to work. After all, the stock market isn't just stocks any more. There are also mutual funds, index funds, exchange traded funds (ETFs) and more. Whatever you decide to invest in, though, another question you should ask yourself, perhaps one you hadn't even considered, is "How should I invest my money?"
This may seem like a very curious question. You might automatically say, "Well, I'll just take all my money at one time and buy." This is called a "lump sum" purchase, and, believe it or not, there are other ways -- better ways -- to put your money to work in the stock market.
Another approach, recommended by many wise investors, is called "dollar cost averaging" (DCA). Dollar cost averaging takes two aspects of your purchase, time and money, and breaks them up. Rather than making just one purchase, you make multiple purchases, regularly, over time. While some people might commit to buying a set number of shares on a periodic basis, DCA instead has you put the same amount of money to work in the market on a periodic basis.
The result is that when the stock is cheaper, you buy more shares, and when the price is higher, you buy fewer shares. In the long run, here's what that means to you: Your average price per share will be less than if you had bought the same number of shares each month. Additionally, if you bought the same number of shares each month, your investment money might run out before the year does.
Dollar cost averaging is called an "investment strategy" -- of which there are many. Investment strategies are techniques designed to take advantage of changes within financial markets, often combined with the needs of the investor. For instance, some investors may watch the market closely, others may simply invest and forget. Dollar cost averaging is a good investment strategy for someone who has found good stocks to invest in, but doesn't want to have to watch them closely.
Let's compare dollar cost averaging to another investment strategy -- rarely successful -- called "timing the market". Performed perfectly, timing the market would have the investor buy stocks at their lowest price and sell them at their highest price. While it fits well within the "buy low, sell high" mantra, it's rarely achieved.
Needless to say, if an investor could do that reliably, he or she could be become quite rich quite rapidly. Those people who try to do this tend to watch the market very closely, pay attention to a number of factors affecting stock price, and frequently buy and use expensive tracking software. They fail more often than they succeed, though -- and not only lose money, but time and effort.
Dollar cost averaging doesn't require extra time or money. In fact, some brokerages will allow you to set up your account to make regular, periodic purchases. This investment strategy can work very well if you combine it with the 10% you pay yourself out of each paycheck.
Dollar cost averaging removes one of the destroyers of investors: emotional trading. Emotional trading happens when either fear or greed stimulates an investor to buy or sell. The emotion of the crowd often persuades people to buy. Most people see a stock going up, and they want to buy it. When they see the stock price plummet, they want to sell it.
Our first example takes place around the turn of this century. Remember the frenzy in internet stocks then? More and more people came into the market, attracted to high-flying internet stocks and bought them for hundreds of dollars. They were buying primarily on emotion. Many people lost a great deal of money by paying high prices for these stocks only to see the stocks fall dramatically in price when the market fell in what has been called the "dot com bomb".
Our second example takes place right after the tragic events of 9/11. What happened when the stock market opened for the first time after 9/11? It dropped dramatically. Many people sold their stocks at rock bottom prices -- only to see them recover within a few weeks. Here, people sold emotionally, on fear.
While we will only touch on it briefly here, diversifying your portfolio protects your overall investments. Diversifying your portfolio means buying more than one stock and buying in more than one industry so that you can spread your risk. An adverse event with one stock will not wipe you out. Many experts recommend never having more than 10% of your portfolio invested in any one stock, and even any one industry. Any stock -- even stocks that seem to be no-brainers -- can stumble and "fall out of bed". As an example of what can happen when you put all your money into one stock, think of the poor employees of Enron who had their retirement funds tied up in Enron stock.
If you diversify your portfolio, buying quality stocks, using dollar cost averaging, over time you will probably enjoy more than the 10% per year historic stock market returns achieved by other investors. The value of this is immeasurable.
The sooner you start, the sooner you start making 10%. And the sooner you can see your money double! It only takes about 7 years, not 10, to double your money if you are making 10% every year.
Let's see how much more you can make by dollar cost averaging than if you buy all your shares at once. Let's say you have $12,000 to invest. Maybe you've made a New Year's Resolution and you decide to buy stock ABC on January 2nd. If stock ABC was selling for $40, you would buy 300 shares.
(Incidentally, many stocks experience something known as "the January effect" -- that is, stocks go up in the first few weeks of the year -- so you may have just bought your shares at a temporary high.)
Instead, you decide to take your $12,000 and use dollar cost averaging by investing $1000 each month into stock ABC, buying as many shares as you can, depending upon the price.
Let's look at the price of your stock over the next year on the second of each month (or the closest business day to that date) and the prices:
|Jan 2||$40||25||Feb 2||$45||22||Mar 2||$43||24||Apr 2||$37||27||May 2||$35||29||Jun 2||$32||31||Jul 2||$30||33||Aug 2||$31||32||Sep 2||$34||29||Oct 2||$40||25||Nov 2||$42||24||Dec 2||$45||22|
At the end of the year, you would have purchased 323 shares. You would have 7.7% more shares than if you had purchased them all at once at the beginning of the year. Add your 7% more shares to your 10% average return--you've made nearly 18% in the past year. You can double your money in about 7 years if your money earns 10% a year, and about 10 years at 7%.
If you benefit from the 10% increase in the stock market per year, and another 7.7% from dollar cost averaging, you would make 17.7% a year At that rate, you could double your money a little over 4 years! While you may not make 10% every year in the stock market, or buy an additional 7.7% shares every year, that possibility would make even the most jaded investor smile!