Your Place in the Market
A good investor is made, not born. Now that you've learned
the folly of trying to time and otherwise outsmart the market, here are
some of the principles of smart investing.
Dollar Cost Averaging
Here's a riddle. Two guys decide to invest in the same stock, which is currently
selling at $10 a share. Both have $600. The first guy buys $600 worth of the
stock at its current price. The second guy buys $100 worth of the stock each month,
spending all his money in six months. Over those six months, the stock goes up to
$11, up again to $12, down to $9, down again to $8, then back up to the original $10.
At the end of those six months, which guy has more stock?
Answer: The second guy.
The first guy, who spent all his money up front, has 60 shares, while the second guy
-- the $100-a-monther -- has 61 shares. This is because he was able to buy more shares with his $100 in the months when the stock price was down. Let's say neither of the two buys any more
shares. From now on, whenever the stock goes up, the second guy will be better off
because he owns more shares. But if it goes down, he won't suffer more than the other
guy because they both spent the same amount of money.
This is the beauty of dollar-cost averaging, the practice of investing a fixed amount
of money at regular intervals.
The amount you earn on an investment depends on how much you bought it
for and how much it is worth when you sell it. If you just buy a fixed amount of
stock, you're out of luck when it goes down. You get all of the downside risk -- there
is no advantage at all for you when the stock's value declines.
If, however, you invest a fixed amount regularly, you will always be spending the same
amount, but getting different numbers of shares for your money. If the price of the
stock is down when it's your time to invest, you will buy more shares -- and
buy them at a relatively low price. The net effect of dollar cost averaging is that
you will end up buying more shares low than high.
As a 401(k) participant you get a natural dose of dollar cost averaging. It takes
discipline to invest a fixed amount regularly, but with a 401(k) plan your contribution
is made on a regular basis with no extra effort for you. Essentially, your dollar cost averaging is done for you.
This too is a distinct advantage of 401(k) investing, particularly if you start early.
Compounding return isn't so much an investment strategy as the natural result of
long-term investing. The strategy is to begin saving early and get the highest
possible return on your investments. Think about it -- if you leave your money making
a certain return for a certain period of time, your money will eventually double. The "Rule of 72" is an easy method for estimating the number of years it will take for an investment's value to double. Simply divide 72 years by the investment's interest rate to find out how many years it will take to double the investment's value. For example, an investment earning 8% annually will take 9 years to double in value (72 divided by 8 = 9). At 9%, it will take 8 years; at 10%, 7.2 years, and so on.
From this we can conclude two things -- it's good to make a high rate of return, and
it's good to make a return over a long period of time. Compounding growth is
exponential growth. If your investment is worth twice as much after seven years,
what will it be worth after 21 years? Not three times as much, not four times as
much, but more than seven times as much as your initial investment.
With long-term investing in a 401(k), you get the full advantage of compounding return
without paying taxes as your money grows.
As your money grows in a 401(k), you don't have to pay taxes
on it. You, rather than Uncle Sam, get the full investing power of your money.
Although you will have to pay taxes when you withdraw money at retirement, letting your
money grow tax-free is the best possible way to build your retirement savings.