Who: This post is for people who have enjoyed the investment basics series so far and want to learn some simple ways to get started with investing.
What: This is the 5th post in a series of posts about the basics of investing. Check out Investing 101, Investing 102, Investing 103, and Investing 104 for your reading pleasure. This post will discuss strategies to invest based on your investing habits and based on the assumption that you don’t like unnecessary fees.

Disclaimer: I am not a financial advisor. The information in this post is just something to think about and does not in any way, shape, or form, constitute financial advice. Additionally, there is only one free lunch in finance so don’t expect these investment strategies to be get rich quick schemes. In fact, since this is a course on investment basics, please realize that these “strategies” I post below are just explanations of commonly used methodologies and will not give you any sort of big advantage, except that they may prevent you from doing stupid things.

Dollar Cost Averaging

Almost everyone has heard of this old favorite. If you haven’t, the synopsis is that dollar cost averaging (dca) is an investment method that calls for equal dollar amount investments over an extended period of time. The idea is that when the market is down, the purchase of a fixed amount of money will purchase more shares and when the market is up, that same amount will purchase fewer shares.

I like dollar cost averaging because it is simple. That simplicity is also a big reason why I dislike dollar cost averaging. It is important to remember that dca does not increase your returns. Instead, one should think of dollar cost averaging as a way to manage volatility.

Since this a course on the basics, let us show a very simple example of dollar cost averaging:

Date Amount Share Price Shares Purchased
01/01/2007 $1000 $10 100
02/01/2007 $1000 $16 62.5
03/01/2007 $1000 $20 50
04/01/2007 $1000 $16 62.5
Total $4000 $14.55 275

In the table above, we see that we purchased $100 worth of shares at the beginning of every month. Since the share prices fluctuated, we were able to purchase a different number of shares at each point in time. The final row shows the total investment and the average cost of the shares purchased. The effectiveness of dollar cost averaging is hotly debated, I’ll give you my own take in an upcoming post.

Do not be swayed by various scenarios that people use to show the effect dca has on returns. Predicting whether dca will be beneficial to you is almost equivalent to trying to time the market (don’t do it). Sometimes dca leaves you in a better position, sometimes it doesn’t. The point is that dca reduces the variation in your wins and your losses.

Buy High, Sell Low

Yes, you read that correctly and no, it is not an investment strategy I advocate. I am mentioning this here because it is what people do, without realizing it. Many people hear the hype about a stock, fund, or asset class and start pouring their money into the asset. This is an example of buying high. Sure, the purchase might not be made at the highEST point, but it is still a purchase made after a lot of buzz has already increased the price of the asset.

Then, to make things worse when the asset runs into some hard times (a period of flat growth, decrease in price, or cooling buzz), nervous owners start to sell. This is a classic example of selling low. We always hear the advice buy low, sell high but it is shocking how many people just ignore the seemingly good advice in practice. Don’t be one of those people!

ETFs or Mutual Funds?

This is a commonly asked question and many are quick to pick their favorite and highlight the advantages of it. The fact of the matter is that your choice depends on a large number of factors. I will discuss some of the factors here.

  • Investment Frequency - If you are investing very frequently, you will *probably* be better off selecting a no load mutual fund for your investments. ETF’s charge a commission with each purchase, so if you’re making a $100 purchase every month and your commission is $10, you are paying a WHOPPING 10% (10/100) commission on each and every trade you make. Even if you hold the security for a LONG period of time, the small difference in the expense ratios (ETF’s are usually lower) won’t make up for the huge percentage of you’re investment you’re losing to commissions. Stay tuned for a calculator which gives a purely mathematical decision on whether ETF’s or Mutual Funds are a better investment decision.
  • Tax Advantages - Many folks in the ETF camp sing the praises of the ETF’s tax benefits. It is important to realize WHY ETF’s have tax benefits. For the most part, ETF’s are passively managed and the turnover rate is relatively low. There isn’t a lot of buying and selling going on and as such, there are far fewer CAPITAL gains that are distributed and taxed! What this means is that ETF’s with a high turnover ratio actually do NOT have tax advantages over mutual funds that have a LOW turnover ratio. So, just keep in mind that the blanket “ETF’s are tax beneficial” statement is not always true.
  • Infrequent/Large Investments - If you’re the type to save up for a few months and then invest a large sum of money into a fund each quarter, it might be in your best interest to invest in an ETF, as opposed to a Mutual Fund. For example, if you are investing $3000 every 3 months, then a $10 commission is 0.33% of your purchase, as opposed to 10% of your purchase. This much smaller overhead cost may eventually make it worthwhile to hold a lower expense ratio ETF, as opposed to a mutual fund.
  • Length of Investment - In general, the longer you hold onto your investment, the more and more the expense ratio differential between ETF’s and Mutual Funds (in general) will matter to you. If you plan to make infrequent purchases and hold onto your investments for a long period of time, (a decade or more) and likelihood of an ETF being a better investment option increases. This is because as time goes on the extra expense ratio of most mutual funds eats away at your earnings more and more. Again, this is not a *simple* calculation, so we are generalizing here (until I come up with a calculator).

Conclusion

In the end, it is exceedingly difficult to beat the market on a regular basis. Any surefire “investment strategies” that claim to give great returns are sure to involve commensurate risk. Remember that these investment strategies presented here are not meant to help you beat the market in some spectacular and tricky way. Instead, these tips are meant to inform you about investing and get you started on your investment plan with relative ease! Stay tuned for the final post in the series, Investing 106: Choosing a Broker!

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