There is information that is nice to know and information that you need to know but what you really need to know is — the difference.
For example, my husband is a history buff with an avid interest in politics. When we have friends over and we are discussing politics or world affairs, he often pops up with not just the year a politician won a race but who ran against him.
I am always amazed at his memory and wonder, “How does he remember that?” It’s crazy! Even though I am always impressed, I do know that is the kind of information that is nice to know but in our work and in our lives, this is not vital information that we need to know.
When it comes to investing in a 401(k) for retirement, some employees have the same level of sophisticated knowledge of investing that my husband has of political history. That is very nice to know and can be very valuable when investing for retirement. Not everyone needs a high level of sophistication in the intricacies of investing to fund their retirement but many employees feel they have to. They really don’t.
If I needed to study the history of U.S. politics and add in a dose of California political history along the way in order for me to discuss politics and cast my ballot, I’d probably never get started. There is such a huge gap in my knowledge on the subject and my husband’s that I don’t think I’d ever bridge it. Fortunately, I don’t have to and neither do investors. There are some key nuggets of information needed to give you a solid base for retirement planning and in this blog, we’re going to discuss one of the most important ones.
A strategy you need to know: Dollar Cost Averaging
Guess what? If you are investing in mutual funds such as equity funds, balanced funds, target funds or even bonds funds in your 401(k), you are already using this strategy now. So it is even more important to understand how it works and to avoid making key mistakes.
Dollar cost averaging is a strategy where you invest in the same investment (the fund choices in your 401(k) plan), with the same amount of money (your payroll deduction) and at regular intervals (whenever you get a paycheck). This strategy works well when the share price fluctuates – the ups and downs are actually an advantage.
Here is an example:
Fluctuating Market Investment Amount Shares Purchased Share Price
Month 1 $100 10 10
Month 2 $100 20 5
Month 3 $100 10 10
Total $300 40 N/A
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Average share cost: $300 / 40 = $7.50
Amount invested $300 and value at the end of Month 3 = $400
(share price $10 x number of shares 40 = $400)
In this example (it is purposely an extreme example), if you were reading the newspapers you’d be in shock that the market dropped 50 percent in Month 2 and be tempted to stop your contributions to your 401(k) or redirect them into a fixed account or a money market.
You might say, “Why should I keep investing when my account balance is dropping?” Well the reason you do it is to buy a boat load of shares knowing that eventually they will come back up and you have the time to wait.
Unfortunately, that was exactly the course of action many employees took in 2008 – they stopped their contributions or changed the contribution to go into a money market account and it was a mistake. Dollar cost averaging investors have a totally different attitude to a market downturn, they think, “This is great because I am buying more shares and when the market turns around, I will be sitting pretty.” Then they sit tight and keep the automatic investment plan going.
Remember, understanding dollar cost averaging is a “need to know.” The more you understand Dollar Cost Averaging, the better. If you are going to study anything, study this.
This was originally published on the Financial Finesse blog for Workplace Financial Planning and Education.