Continuing on in the 3 Investment Principles series (If you haven’t caught the first two here they are: Time Value of Money and Pay Yourself First) we come to the final principle: Dollar-Cost Averaging (DCA). The aim of DCA is to reduce the risk associated with a single, large investment by spreading out the investing (and risk) over time. Everyone has heard the token financial advice, “buy low, sell high.” Seems simple enough, but in reality no one can predict exactly when a stock will bottom out. By investing a fixed dollar amount at regular intervals (weekly, monthly, etc.) regardless of share price, you will end up buying more shares when the price is low and less when the price is high, thereby maximizing your total return.

An example of this from youngmoney.com:

“Dollar cost averaging works like this: systematic investments are made to an investment account. For this example we will say on a monthly basis. To keep things simple we will also say that the investment account is allocated 100% into one growth fund. We will use $100 as the monthly investment amount. Now, depending on how the market is doing that fund’s price is going to fluctuate from day to day. So let’s look at a six-month example in the table below.

In the example above, you have invested $600 and your account is now worth $791.73. Over the six-month period, you paid an average of $14.33 per share. If you would have taken all $600 and purchased the shares at the beginning of the six months, you would have purchased 30 shares and your account would now be worth only $750. For this example, using dollar cost averaging has increased your account by over 5%! Of course the above scenario is just one example of using dollar cost averaging. There are many.”

This isn’t to say that this method of investing doesn’t have its critics. DCA operates on two assumptions: 1) the investment (stock, mutual fund, etc.) follows an overall positive trend over the investment time frame, meaning, dollar-cost averaging isn’t going to help if the investment you’re putting money into ends up losing value in the long run. 2) If you happen to get extremely lucky and start investing at the bottom of a long-term price trend you would be better off buying a lump sum…good luck timing the market!! John Wagonner explains in USA Today, “Dollar-cost averaging typically does best when an investment goes sideways or down for years and then, at the end of the period, suddenly breaks to the upside.”

As is the case with nearly everything in finance, time frame matters. “Regardless of the amount of money that you have to invest, dollar-cost averaging is a long-term strategy,” explains Jim McWhinney for Investopedia.com, “While financial markets are in a constant state of flux, they tend to movie in the same general direction over fairly long periods of time. Bear markets and bull markets can last for months, if not year. Because of these trends, dollar-cost averaging is generally not a particularly valuable short-term strategy.”

In the end I like DCA for one simple reason, it builds a habit pattern of investing in season and out of season. Its very easy to form the wrong habits in an affluent culture like our own. It seems everyone, but you, always has the latest gadget, toy, car, etc. Spending, saving, investing are all habits. The purpose of this 3-part series on investment principles is to help make good habit patterns, ones that create wealth and enable you to live the High Life.

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If you want to create wealth you must either save more or spend less…that’s it. Why is it so hard then? Most people have the best intentions when it comes to doing these things, but at the end of the month, when the bills and statements arrive, the letdown begins. You realize that your money has yet again pulled a Houdini and is no where to be found…where did it go…you stand there puzzled, your empty Starbucks cups and Hollywood Video receipts mock your weakness. And so the cycle goes…unless you make a change. Thus, the second of the three investment principles every young person should know:

#2: Pay Yourself First

Most people pay everyone else before they pay themselves. They hope at the end of the month they will have some money left over to put towards savings or investments, but it rarely happens, its too easy to spend money. Paying yourself first means exactly that: when you get your paycheck, before you start paying bills, going grocery shopping, filling your gas tank, etc….take a percentage and put it in savings or investments. If you do this you will never go a month without saving money. At the end of the month you will still probably spend all your money…its what we are all great at, but the savings will already be in the bank, safe and sound.

The easiest way to pay yourself first is to set up automatic fund transfers on the days you receive your paychecks. This way you won’t even realize the money is gone, you’ll budget and spend according to the new amount. Spending is largely psychological, if you start out with a smaller amount your mind will tell you that you have to spend less, be more frugal.

Finally, an example of the power of paying yourself first from financial educator David Bach, author of “The Automatic Millionaire”:

“Let’s assume you make $50,000 a year. That’s about $2,000 every two weeks, which is how most people are paid. So to save 10 percent of your income, which is less than an hour a day of savings, you’d have to save $200 every two weeks — or $14 a day.

If you invested $200 every two weeks for 35 years in a retirement account that earned an annual return of 10 percent what would you have? Quite a pot of gold: $1,678,293.78.”

**Author’s Note: I actually pay myself second, I give the first 10% of my income to my local church, also known as tithing…but the principle remains the same.

Since my last post I have had time to read more of Ramit Sethi’s, I Will Teach You To Be Rich blog. As I have read the articles and seen the demand for simple financial education…and after many discussions with friends it has become obvious to me that many college and twenty somethings have not been introduced to basic money and investment principles that most close to finance would consider fundamental. For the next few days I’ll be laying out the three investment principles every young person should know.

#1 - The Time Value of Money

The basic premise of the time value of money is that all else being equal an investor is better off receiving a certain amount of money today than he is receiving that same amount of money in the future. Basically, money now is better than money tomorrow. To most people this is instinctive, of course you would want money NOW! But why? One would assume that the value of $1 today is equal to the value of $1 a year from now, but this assumption is wrong. The dollar received today is more valuable because of all the ways you can make it grow. Just by putting it in a savings account you’ll at least earn interest on it, thereby increasing its future value Here is an example:

You are given the choice between
Option A: $100,000 today
Option B: $100,000 in 3 years.

Lets say you decide to take Option A and invest your $100,000 in a savings account with a simple annual rate of 5%.

Future value of investment at end of first year:
= ($100,000 x 0.05) + $100,000
= $105,000

Next you leave this money untouched and let interest continue to accumulate

Future value of investment at end of second year:
= $100,500 x (1+0.05)
= $110,250

These equations rolled together would be equivalent to:

Future Value = $100,000 x (1+0.05) x (1+0.05) OR
$100,000 x (1+0.05)^2

Using this logic after three years the value of the $100,000 would be:
= $100,000 x (1+0.05)^3
= $115,762.50

This equation allows us to calculate multiple years or periods of interest without having to add each period up individually and is the basis for one of the most basic finance equations out there:

Future Value = Present Value x (1+interest rate)^number of periods

NOW, before you zone out from too many numbers. Here is the bottom line. Option A, in this case, is $15,762.50 more valuable than Option B, who’s future value is equal to its present value. And remember, this is just assuming you put the money into a savings account making 5% interest. Option A could in fact be much more valuable if you instead invested the money in the stock market which has averaged approximately %10 percent return per year over the past several decades.

Compounding interest (another discussion in itself) allows our youth to work for us in mighty ways so that the money we have today is in fact much more valuable than money we will have in the future. Albert Einstein was quoted as saying, “The most powerful force in the universe is compound interest.” Understanding the time value of money principle allows us to harness this force and create wealth.