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April 20, 2010

Financial Literacy 101: A simple and steady investing strategy

Sixth in a series for
Financial Literacy Month

At Sound Mind Investing, we're participating in National Financial Literacy Month by posting a series of articles covering basic principles/strategies related to investing and personal finance.

Here's post six — about an investing strategy that is easy to understand and implement.

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A consistent theme of the Sound Mind Investing philosophy is the importance of taking charge of your own financial future by becoming an "initiator" rather than a "responder." Initiators take action based on specific guidelines that flow from a specific strategy. Initiators, as the old saying goes, "plan their work and work their plan."
At SMI, we like "formula" strategies. A formula strategy requires you to make your buying and selling decisions based solely on mechanical guidelines. There is no judgment involved; it's all automatic. Such strategies protect you against your own emotions and the tendency to go along with the crowd.

Probably the best-known formula strategy is dollar-cost-averaging (DCA). It's not complicated. It's not time-consuming. In fact, nothing could be simpler.

Here's all you do: (1) invest the same amount of money (2) at regular time intervals. That's it.

The amount and frequency are up to you. The important thing is to pick an amount you can stick with faithfully over many years.

Your constant dollar investment automatically results in buying more shares when prices fall and buying fewer shares when prices rise. In effect, you are buying more at bargain prices and relatively little at what might be considered high prices. (Of course, only when you look back years from now will you know when prices really were bargains and when prices were too high.)

The beauty of DCA is that it frees you from the worry of whether you're buying stocks at the "wrong" time.

It is critically important to ignore all market fluctuations when employing a dollar-cost-averaging strategy. Most investors who obtain poor returns in the market are victims of their own emotions. Only after stock prices have risen sharply do they work up enough courage to buy stock fund shares. And they often sell when they become fearful after prices have plunged. The consequence is that they buy high and sell low, the very opposite of their goal.

It is important, then, not to let your emotions control you. You must exercise the discipline of maintaining your systematic investment program.

The benefits of DCA can be illustrated with a simple example. Let’s assume you can afford to invest $100 every month in your stock fund program. At the time of your first new investment, the fund shares sell for $10.

The next month, the market soars and you pay $14 for your shares. Finally, the third month the market falls back, and your fund retreats to $12, midway between your two buying levels.

Ordinarily, that would put you at break-even. But look at what has happened. The first month you were able to buy ten shares at $10 per share. The second month you acquired only 7.1429 shares at $14 per share. Now, at $12 each, your 17.1429 shares are worth $205.71. Instead at being at break-even, you have a small profit.

One caution: DCA does not protect you against losses. While it does result in your average cost per share being lower than the average price of the shares over time, in a bear market you can nevertheless have temporary losses.

In summary, dollar-cost-averaging is the systematic investing of a fixed amount of money on a regular basis, usually monthly. DCA eliminates the need to ask the question, "Is this a good time to buy stocks?" As far as DCA investors are concerned, every month is a good month.