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Investing 103: Understanding Best Practices for Saving and Investment

While “Investing 102” explained concepts that are integral to understanding different investment philosophies, this article will focus on elucidating two concepts that underpin “best practices” for maximizing your investments. 

Compounding.  In our recent article on saving for retirement, we explained that one’s starting age for saving is the most significant factor in determining what percentage of one’s salary must be set aside for retirement.  The younger you start saving, the better.  The main reason for this is compounding.  Compounding refers to the accumulation of earnings (interest, dividends, or capital gains) not just on the principal (i.e. the initial investment) but also on previously accrued earnings that have been reinvested. 

For savers, this phenomenon works strongly in their favor.  For example, finance textbooks will often give the example of John, who saved $10,000 per year for ten years from age 25 to 35 and ended up with $1,051,743 in savings when he retired at 65, versus Jack, who saved $10,000 per year for thirty years from age 35 to 65 and ended up with only $944,607 when he retired at 65.*  John had the benefit of additional years of compounding, which outweighed the fact that Jack saved for twenty years more.

For borrowers, this phenomenon works strongly against them, since compounding also applies, for instance, to interest charged on a loan or credit card balance.  Consider what would happen if, despite his impeccable retirement savings habit, John had neglected to pay a $1,000 credit card bill incurred at age 25 until he reached age 35.  With monthly compounding and a 15% nominal APR (interest rate), John would owe $4,385 at the end of 10 years.

Make sure that compounding is your friend, not your enemy, by starting to save early and avoiding unnecessary debt!

Dollar Cost Averaging.  Another financial phenomenon that could be either friend or foe is the volatility of the stock market.  While historically the market has increased an average of 10% per year, every investor knows that this has been anything but a straight line trajectory and that returns can vary dramatically on any given day.  Since investors who attempt to “time the market” (buy equities only when they believe the market is poised to rise) typically do so to their detriment, financial professionals advise instead dollar cost averaging, or DCA. 

DCA refers to investing a fixed amount of money into a particular investment on a monthly basis, regardless of market swings.  This results in a disciplined regimen of buying more shares when the price is low and fewer shares when the price is high.  For example, if Jack invests $500 automatically on the 1st day of each month into the DFA US Large Company mutual fund, he would have bought 33 shares on May 1, 2014 (when the price was only $14.88/share) but only 30 shares on May 1, 2015 (when the price was $16.64/share).  Fortunately, for those who save automatically from their paychecks to retirement plans, you are already practicing DCA.  However, it is a “best practice” for saving into a taxable investment portfolio or IRA as well.

For any clients who wish to become better friends with market volatility by setting up or increasing your DCA, give us a call!  It’s never too late to turn these foes into friends.

 

* This example assumed a 7% annual return on their investments.

     
 

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