It is an obvious question asked to fund managers, wealth managers and chief investment strategists more often than any other over the years: “How do you allocate new money?”
While everyone has their own opinion about allocations, there is one opinion that suggests using four tranches (“slices” in French) of $250,000 as an accepted practice worth considering when presented with investing $1 million dollars.
For illustrative purposes, this means committing to $250,000 the first month, $250,000 the second, third and fourth. Each tranche has an “expected life.” The risk/volatility, also known as standard deviation, is lower on the monthly level when compared to the weekly level.
Schedule Your Investing
Financial advisors have long talked about investing on a set schedule as a good way to develop discipline, which is essential to becoming a better long-term investor. Basically, you dollar-cost average your money in equal portions, at regular intervals, and ignore market ups and downs.
In and of itself, this is a good enough reason why dollar cost averaging attracts investors—and why it is even more attractive to new investors or those just starting out. And so is a copy of “The Intelligent Investor,” written by Benjamin Graham, the father of dollar cost averaging. The principle behind dollar cost averaging has not changed since his book came out in 1949.
Essentially, when prices drop, your fixed dollar investment buys more shares; when prices rise, your fixed dollar amount buys fewer shares. A big part of Graham’s, and Warren Buffett’s message is know how to manage your risk by creating a margin of safety. Dollar cost averaging always results in slightly more shares being purchased as long as prices fluctuate fairly evenly, resulting in lower average cost.
However, if prices stay constant, or fall consistently, this method does not work. You might overpay for shares some weeks, but you’ll also underpay other weeks. It is called “systematic investing,” and it does not guarantee a profit or protect against loss. Investors should consider their willingness to keep investing when share prices are declining.
Investing in a Volatile Market
Simply put, dollar-cost averaging is a strategy to reduce the impact of volatility by spreading out your stock or fund purchases over time so you’re not buying shares at a high point for prices. Use dollar cost averaging and you eliminate the temptation to “time” the market. When you attempt to time the market, you run the risk of missing out on great buying opportunities anyway, so that’s when you must ask yourself: “Why am I paying higher share prices when I don’t need to?”
In particular, Warren Buffett’s advice includes employing dollar-cost averaging to buy shares of S&P 500 index funds to get exposure to the broader market, thus avoiding the temptation to putting all of your money into a single stock. He has stated many times over that he feels index funds are a great way for the average investor to grow wealth, but more education is needed.
At first, the concept of dollar cost averaging might seem unfamiliar to you until you think about your employer-sponsored 401(k) plan at work. Aren’t you already investing money in regular amounts of money that you’ve earned into a retirement plan via your payroll deduction? You’re not waiting or timing when you make purchases based on market movements, are you?
Dollar cost averaging can be used to invest for any long-term goal regardless of volatility. As one “nattering nabob of negativism” quipped, “Clearly, you’re missing out on higher returns because you’re not investing all at once in a lump sum!” OK. So, generally speaking, that’s true. A 2012 study by Vanguard found investing in a lump sum vs. dollar-cost averaging produced better results 66 percent of the time. But lump sums aren’t for everyone.
However, depending on your risk tolerance, and your appreciation of dollar cost averaging and lowering your short-term downside risk, the money held in cash for systematic investing may produce lower returns, but carries less risk. Which is more important to you?
Don’t Go At It Alone
One advantage of working with investment professionals, like ours at Hefren-Tillotson, is that he or she may provide the encouragement you need to move from thinking about your goals to actually listing them and then taking steps to achieve them.
While everyone’s circumstances are different, there are essentially four steps to creating a strategy for meeting your goals that will work for just about every person and situation,
according to www.FINRA.org:
- Identify your most important short-, medium- and long-term financial goals
- Estimate how much each of your goals will likely cost
- Set up separate savings or investment accounts for each of your major goals
- Choose investments suited to meeting each of your goals based on your time frame and your tolerance for risk
Before you can choose investments to meet a particular goal, you need to have an idea of what the goal will cost and your time frame for meeting the goal.
FINRA also suggests that for goals more than a few years away, consider the impact of inflation on your assets—something you can figure out using an online calculator. Historically, inflation has averaged about 3 percent per year. Keep in mind, too, the costs of tuition at both public and private colleges typically rise even faster. That means you’ll have to earn enough on your investments to offset these rising costs.
Take stock of your current debts and try to pay them down. The less money you put toward paying off outstanding debts and interest charges, the more you will have to save and invest for your future. We can help you plan at Hefren-Tillotson. Contact us today for more information.