Eric Tyson - Investing For Dummies

Have the courage to be a contrarian. No one likes to feel that he is jumping on board a sinking ship or supporting a losing cause. However, just as in shopping for something at retail stores, the best time to buy something of quality is when its price is reduced.

Diversify. As I discuss in Chapter 2, the values of different investments don’t move in tandem. So when you invest in growth investments, such as stocks or real estate, your portfolio’s value will have a smoother ride if you diversify properly.

Invest more in what you know. Over the years, I’ve met successful investors who have built substantial wealth without spending gobs of their free time researching, selecting, and monitoring investments. For example, some investors concentrate more on real estate because that’s what they best understand and feel comfortable with. Others put more money in stocks for the same reason. No one-size-fits-all code exists for successful investors. Just be careful that you don’t put all your investing eggs in the same basket (for example, don’t load up on stocks in the same industry that you believe you know a lot about).

Don’t invest in too many different things. Diversification is good to a point. But if you purchase so many investments that you can’t perform a basic annual review of all of them (for example, reading the annual reports from your mutual and exchange-traded funds), you have too many investments.

Be more aggressive with investments inside retirement accounts. When you hit your retirement years, you’ll probably begin to live off your non-retirement account investments first. Allowing your retirement accounts to continue growing can generally save you tax dollars. Therefore, you should be relatively less aggressive with investments outside of retirement accounts because that money may be invested for a shorter time period.

Dollar cost averaging (DCA) is the practice of investing a regular amount of money at set time intervals, such as monthly or quarterly, into volatile investments, such as stocks and stock mutual funds. If you’ve ever had money deducted from your paycheck and invested it into a retirement savings plan investment account that holds stocks and bonds, you’ve done DCA.

Most people invest a portion of their employment compensation as they earn it, but if you have extra cash sitting around, you can choose to invest that money in one fell swoop or to invest it gradually via DCA. The biggest appeal of gradually feeding money into the market via DCA is that you don’t dump all your money into a potentially overheated investment just before a major drop. Thus, DCA helps shy investors psychologically ease into riskier investments.

DCA is made to order for skittish investors with large lump sums of money sitting in safe investments like CDs or savings accounts. For example, using DCA, an investor with $100,000 to invest in stock funds can feed her money into investments gradually — say, at the rate of $12,500 or so quarterly over two years — instead of investing her entire $100,000 in stocks at once and possibly buying all of her shares at or near a market peak. Most large investment companies, especially mutual funds, allow investors to establish automatic investment plans so the DCA occurs without an investor’s ongoing involvement.

Of course, like any risk-reducing investment strategy, DCA has drawbacks. If growth investments appreciate (as they’re supposed to), a DCA investor misses out on earning higher returns on his money awaiting investment. Finance professors Richard E. Williams and Peter W. Bacon found that approximately two-thirds of the time, a lump-sum U.S. stock market investor earned higher first-year returns than an investor who fed the money in monthly over the first year.

However, knowing that you’ll probably be ahead most of the time if you dump a lump sum into the stock market is little solace if you happen to invest just before a major plunge in prices. In the fall of 1987, the U.S. stock market, as measured by the Dow Jones Industrial Average, plummeted 36 percent, and from late 2007 to early 2009, the market shed 55 percent of its value. The COVID-19 stock market slide, which lopped 36 percent off the Dow’s value in early 2020, was another such period.

So investors who fear that stocks are due for such a major correction should practice DCA, right? Well, not so fast. Apprehensive investors who shun lump-sum investments and use DCA are more likely to stop the DCA investment process if prices plunge, thereby defeating the benefit of doing DCA during a declining market.

So what’s an investor with a lump sum of money to do?

First, weigh the significance of the lump sum to you. Although $100,000 is a big chunk of most people’s net worth, it’s only 10 percent if your net worth is $1,000,000. It’s not worth a millionaire’s time to use DCA for $100,000. If the cash you have to invest is less than a quarter of your net worth, you may not want to bother with DCA.

Second, consider how aggressively you invest (or invested) your money. For example, if you aggressively invested your money through an employer’s retirement plan that you roll over, don’t waste your time on DCA.

DCA makes sense for investors with a large chunk of their net worth in cash who want to minimize the risk of transferring that cash to riskier investments, such as stocks. If you fancy yourself a market prognosticator, you can also assess the current valuation of stocks. Thinking that stocks are pricey (and thus riper for a fall) increases the appeal of DCA.

If you use DCA too quickly, you may not give the market sufficient time for a correction to unfold, during and after which some of the DCA purchases may take place. If you practice DCA over too long of a period of time, you may miss a major upswing in stock prices. I suggest using DCA over one to two years to strike a balance.

As for the times of the year that you should use DCA, mutual fund and exchange-traded fund investors should use DCA early in each calendar quarter because funds that make taxable distributions tend to do so late in the quarter.

Your money that awaits investment in DCA should have a suitable parking place. Select a high-yielding money market fund that’s appropriate for your tax situation.

One last critical point: When you use DCA, establish an automatic investment plan so you’re less likely to chicken out. And for the more courageous, you may want to try an alternative strategy to DCA — value averaging, which allows you to invest more if prices are falling and invest less if prices are rising.

Suppose, for example, that you want to value-average $500 per quarter into an aggressive stock fund. After your first quarterly $500 investment, the fund drops 10 percent, reducing your account balance to $450. Value averaging suggests that you invest $500 the next quarter plus another $50 to make up the shortfall. (Conversely, if the fund value had increased to $550 after your first investment, you would invest only $450 in the second round.) Increasing the amount that you invest requires confidence when prices fall, but doing so magnifies your returns when prices ultimately turn around.

Many well-intentioned parents want to save for their children’s future educational expenses. The mistake they often make, however, is putting money in accounts in their child’s name (in so-called custodial accounts ) or saving outside of retirement accounts in general.