Finish Rich On A Shoestring
As pointed out in yesterday’s stupid money mistakes post, the biggest excuse most people have for not investing is “I don’t have enough money to open an account”. While it’s true that most mutual funds require a hefty initial deposit (usually several thousand dollars), there is a road less traveled. It doesn’t generate headlines because it’s not fancy, and you’re not going to hit a homerun and make millions with a couple of hot stocks, and you don’t need a broker to do it. But in the end, it’s as sure a thing as the sun rising and setting every day.
You certainly won’t become a millionaire overnight, not that you won’t be able to put aside a significant amount of money (at least a couple hundred thousand dollars). And it can be done on $50 per month. How, you ask? Through the magic of dollar cost averaging. Now don’t think of it as some new fancy investing technique, as personal finance websites have been covering the subject for years. Actually it’s probably your best bet to (at least) retire comfortably.
How does it work?
Most of us don’t have an extra couple thousand dollars lying around, waiting to be invested. Furthermore, many aspiring investors tend to stay out of certain investment markets (such as the stock market) because of its volatility (prices go up and down in a seemingly random way). All investment markets are volatile, not only the stock market. It’s not recommended to try to second-guess the market in order to time your investments. Although you will find many opinions about the direction of the stock market, even the experts struggle to accurately judge market timing (knowing when to buy and when to sell). Drip-feeding your savings will allow you to use and take advantage of dollar-cost averaging. For this technique to work, three things are required:
- You must decide exactly how much money you can invest each month. Make sure you are financially capable of keeping the amount consistent, otherwise the plan will not be as effective
- Select an investment (index funds are particularly appropriate; more on that later) that you want to hold for the long term, at least 10 years or longer
- At regular intervals, invest that money into the security you’ve chosen. Most mutual funds now offer automatic withdrawal plans so you don’t even have to think about it
Why does it work?
The U.S. Stock market is said to have an average 11% annual return over the past 80 years (more precisely, 10.7%). This is the rate that is often used to help pension funding, retirement planning, and more generally as a benchmark for investment and savings decisions. It essentially means that on average, over the past 80 years, the market as a whole has grown by 11% per year. That figure includes market crashes. Even when the market crashes, if you can leave the money in the market it will, over time, earn roughly 11%. The only slight problem is that you have to leave the money there for the long term.
Actually, times when the market falls offer a great opportunity to buy, since stock prices are lower. So your same investment buys you more shares, and you’re in a position to benefit more, provided that the market rebounds.
Dollar-cost averaging not only allows you to ignore the volatility of the stock market, it also allows you take advantage of it. To make use of dollar-cost averaging, you must be in the market for the long term. That’s when the power of compound interest kicks in, in your favor.
Compound interest means that the interest you earn will include interest calculated on interest. For example, if an amount of $5,000 is invested for 2 years, and the interest rate is 10%, compounded yearly:
- At the end of the first year, the interest would be ($5,000*0.10) or $500
- In the second year, the interest rate of 10% will apply not only to the $5,000 but also to the $500 interest of the first year. This, in the second year, the interest would be ($5,500*0.10) or $550.
And so it goes year after year. So it becomes obvious that the sooner you start investing, the longer you have your money at work and the more money you have to compound. Try out this calculator:
What should I invest in?
While dollar cost averaging reduces market risk (by eliminating the need for market timing), it is still possible for an investor to lose his/her shirt by investing in the wrong company. The best way to minimize company risk is to invest in a stock mutual fund. A stock mutual fund is simply a pool of stocks owned by a group of investors. A big mutual fund might have 100,000 investors and might own stock in 100 different companies. The risk is lower because of the large portfolio of stocks.
Mutual funds come in all flavors (which is beyond the scope of this article) but the one of particular interest to us right now is the index fund. Index funds are mutual funds that attempt to copy the performance of a stock market index, for example the S&P. The S&P 500 is the average of the top 500 companies on the stock market, and they represent roughly 75% of the value of the entire market. As such, index funds that mirror the S&P represent the best way to achieve meaningful diversification with a minimal investment.
That’s where your money should be.
So, what have we learned today?
- You must start your investing program immediately
- Dollar cost averaging is convenient and smart for most of us
- Index funds are the safest, simplest way to invest in the market
But you’ve probably heard it all before. Now is the time to actually DO something about it.
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