Step Two: Fund your retirement account systematically every month with an automatic contribution.
You’ve heard me say this over and over again, make contributions automatic every month. But why? Why is it so smart to contribute systematically?
The long and short of it is Dollar Cost Averaging. I don’t want to scare any of you off with high finance lingo but trust me, dollar cost averaging is neither complicated nor high finance so bear with me.
Let’s say that your rich uncle died and gave you $100,000 - nice! The very next day you take the whole lump sum of money and dump it into the stock market and the day after that, the market falls 40%. Your $100k is now only worth $60k, so you freak out and pull all of your money out of the market because you don't want to suffer any more losses.
Then lets say, one week later the market is up 60% and you missed the up-swing because you were out of the game.
How would you feel? Horrible, You missed your chance!
Guys, this is exactly what could have happened to you last spring if you did not take advantage of dollar cost averaging with your contributions.
Here’s how it works:
Let’s say you get the same $100,000 from your dead rich uncle. Only this time you divide it into 20 pieces of $5,000 each and invest each piece on the first Monday of the week for the next 20 weeks. If the stock market declines as soon as you invest the first $5k you can take comfort in the other $95k you still have in cash. When the market increases you will be poised to take advantage of the swing because you are systematically investing, no matter what the market is doing.
The other benefit to systematically contributing to the market is lowering your average costs of shares purchased. For example, your first week you might buy shares of a specific investment at $5 per share, then next week you might buy at $4 per share and the week after you may buy at $4.50 per share. So the average cost of the shares is $4.50. Now you are really taking advantage of fluctuations in market because you are buying at lower cost than you would have had you put all your money in on the first day.
Buy Low, Sell High
Everyone knows that the ultimate goal of investing is to buy low and sell high but because of emotion and human nature many people do just the opposite. Use dollar cost averaging to help you avoid falling into the trap. Make it automatic and you can create the discipline that you need.
Who would have guessed that after the miserable winter of 2008 to 2009 in the stock market, March was the month to have your money in! I certainly would not have made that prediction, but I took advantage of it because while the market was falling I was buying every month at lower and lower prices. It’s not rocket science but there is an element of discipline that is required. The good news is that you can create the discipline for yourself.