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For the next few newsletters I’d like to focus on what I believe are some commonly misunderstood financial concepts. More often than not this means people misunderstand how a particular financial concept can be applied to make a difference in their lives.This approach could be helpful in raising awareness around simple techniques that can help people be more successful financially. Throughout this series, we will focus on topics like: Dollar-Cost Averaging, The Time Value of Money, Simple vs. Compound Interest, Active vs. Passive Investing and why these concepts should matter to you. Additionally, if you have any specific topics that you believe would be well served if covered in a newsletter, please forward your suggestions to any member of the Allied team!
We’ll begin with Dollar-Cost Averaging (DCA). Many people have heard an old adage, “save early, save often,” but when I speak with clients; particularly those without a formal employer sponsored retirement plan, saving early and often can be cumbersome at best. Further, it’s one thing to hear someone tell you to invest, but it’s entirely different to step back and understand why the routine is not only convenient, but also necessary to your financial success. The purpose of DCA is to accomplish two main things. The first is to mathematically reduce your cost of investing over the long-term. The second, and perhaps even more powerful reason to incorporate DCA into your investment program is that markets tend to be volatile over time and in some cases; like 2008, volatility spikes to a terribly uncomfortable level. Dollar cost averaging can help to reduce the emotional discomfort associated with volatility and instead change the way you view the market’s gyrations.
Can you guess how frequently the US stock market declines by at least 10%? On average, it’s at least once per year. The last time this happened was in the beginning of 2016 and in only a matter of weeks the market had recovered its losses. So how can you take advantage of these pricing opportunities? By creating the routine of investing. In essence, DCA is the act of creating a simple and consistent investment of cash into market securities on a systematic basis, perhaps monthly. Many people can and do accomplish this by contributing to a retirement plan at work; however, the same principal can be applied outside of employer sponsored retirement plans. This concept is immediately actionable and we can help you to create a personal schedule of investment that works for your budget.
An analogy I like to use: when your favorite store mails you a coupon for 10% or 20% of anything in the store you’re more likely to go to that store on the weekend and pick something up. However, when the stock market declines by 10% or 20% (goes on sale), most people would tend to run away. In my mind, the stock market is the only appreciating asset that goes on sale and people don’t want to buy it. The challenge here is that it can be very dicult to wait for the perfect “sale” opportunity to invest. In fact, with how quickly the market has recovered from recent setbacks, it could be nearly impossible. However, if you had a routine where you were investing monthly as part of a normal schedule, you would have benefited from 2-3 sale opportunities during the first few months of 2016. Now, let’s look at why those sales are important.
Let’s say that you like to wait for tax time to see your accountant and invest in your traditional IRA for your tax deduction. I’m going to explain why this can be potentially damaging to your long-term financial success. It’s something I call “timing risk;” which is when you take your $5,500 and invest it on April 1st in a fund that costs $100 per share leaving you with 55 shares. Then unfortunately on April 10th, the market starts a prolonged 12 month decline losing 1.5% per month or $842.60 cumulatively. Stings a bit!
What if; on the other hand, you had decided to establish a routine where you would invest $458.33 per month until you reached the same $5,500 investment level? At the end of the 12 month period, you would have 59.85 shares versus the 55 shares in the original illustration with a balance of approximately $5,068. Your loss would be cut to $431 essentially reducing your losses by roughly half. What’s more, you have an additional 4.85 shares meaning that as the market recovers from its recent losses, you’ll have additional shares participating in that recovery thus amplifying your account balance post recovery. This illustration helps to emphasize why the routine of investing is a very important component of any long-term successful investment strategy.
You may notice that were the example reversed and the market went up for 12 months instead of down that the experience would not be as favorable. However, this is again where we look to the emotional reality of investing. We favor the gradual infusion of cash into the market over time rather than the “all-in” approach. The fear of large short-term losses can derail investment success and reduce your commitment to investing for the long-term . As such, we advocate for incorporating a systematic approach that helps you to benefit from the market’s volatility as it is also rather routine; so we should take advantage of it, since it won’t be going away.
Article Series by David A. Younis, CFP ®, Director of Financial Services
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