Determining the best time to invest can be a nerve wracking business. Ideally, we’d all invest at the market’s low point, and watch our returns climb as we sat back and congratulated ourselves on our stellar timing and market acumen. Alas, we are stuck with real life, where markets are unpredictable and determining the very best time to buy nearly impossible.
One purported solution to this dilemma is dollar cost averaging. Rather than putting all of our money into the market at one time, we hold on to it, doling it out a little bit at a time, feeling secure that we are lowering our average share price with each investment.
Lower average purchase price
Dollar cost averaging is a strategy based on mathematical averages. Say, for example, you have $10,000 to invest. Rather than investing it all at once, you decide to invest $100 a month for a little over 8 years. That $100 will buy more shares in the months when prices are low, and fewer when they are high. The theory is that this helps to smooth the volatility of your investment by lowering your average price per share.
To an extent, the logic is indisputable. If you buy more shares when the price is low, and fewer when the price is high, your average price per share will be closer to the low side than the high side. That’s how averages work. The mistake is in assuming that reducing the volatility of the purchase price will have a similar effect on the performance of the investment.
The presumed advantages of dollar cost averaging have been soundly debunked, unfortunately. In 1992, larger brains than mine compared dollar cost averaging to two other investment strategies – buy and hold and optimal rebalancing. While dollar cost averaging involves doling out your investment a little bit at time, both buy and hold and optimal rebalancing involve a single, lump sum investment.
Dollar cost averaging as a strategy came in dead last. Essentially, the reduction in average price from dollar cost averaging was more than offset by the loss of investment gain. More simply, the lower average share price doesn’t make up for the return lost by the money that is waiting to be invested. (The owners of those larger brains I mentioned are John Knight and Lewis Mandell, and they published their findings in the Financial Services Review (Vol.2, Issue 1) in a paper entitled “Nobody Gains from Dollar Cost Averaging: Analytical, Numerical and Empirical Results.”)
A comforting myth
It’s no great mystery why we find dollar cost averaging so appealing. As a concept, it plays nicely into our reservations about investing. None of us wants to risk putting the entirety of our investable capital into the market on the most expensive day of the year. Since stock prices are unpredictable, there is great allure in a strategy that takes the guesswork out of determining the very best time to buy, and minimizes the risk that we will have paid a premium for something we could have gotten more cheaply had we timed things differently. However, the evidence suggests that the risks of buying high are far lower than those of holding back and not putting all of our investable capital to work at one time.
Regular investing is important
No one – not Knight and Mandell, and certainly not me – is saying that regular investing is a poor strategy. It’s important to note that, from a definition standpoint, dollar cost averaging involves an amount of money you already have – like the $10,000 in our example above. On the other hand, Knight and Mandell note that regular investments from periodic income would be considered lump sum investments, since you are investing all of your available capital at one time.
The moral of the story is this – if you’ve earmarked it for investing, invest it, and let share prices fall (or not) where they may.
Investments with tax benefits are an attractive option for diversifying your portfolio. The IRS offers tax breaks for savings goals such as retirement and education, but you can reduce your taxes further by looking beyond these options. The following products either offer tax-free earnings, or are more tax-efficient than many people realiz
1. Municipal Bonds
Municipal bonds are those issued by a state or local government, and they can be very attractive to those looking to cut their tax bill. Many municipal bonds pay interest that is exempt from federal taxes, and often from state and local taxes. Municipal bonds fund projects for the community, like schools or highways, so they are also a way to invest in improving the place where you live.
It’s important to remember that it is only interest on municipal bonds that is exempt from federal tax. Any discount at purchase or profit on the sale of a bond may be taxable. Also, investing in municipal bonds for their tax exemption requires some due diligence. Bonds issued to fund projects that don’t primarily benefit the community pay interest that is taxable, and certain other municipal bonds are subject to the Alternative Minimum Tax.
2. Life Insurance
Life insurance as an investment usually brings our some pretty strong opinions, many of them negative. However, I am a believer that there are no inherently evil products – only unsuitable ones. And what is unsuitable for one investor might be a perfect fit for another. Life insurance comes in two broad categories – term and permanent. Permanent life insurance includes a cash value account, which can be invested to earn a return. Those earnings are exempt from federal tax. What makes permanent life insurance a potential investment for the living is that the policyholder can borrow this money, tax free, for pretty much any purpose.
It bears repeating that this is a contentious subject. Permanent life insurance premiums generally run over ten times those of term, and of course a good chunk of that goes to fees and cost of insurance. But for those who are looking for tax-advantaged investing options and have maxed out their retirement contributions, life insurance is worth a look.
ETFs are a bit different than the other two items on this list in that they do not enjoy any special tax treatment from the federal government. However, I think they belong in a discussion about reducing tax liability because they are remarkably more tax efficient than their alter ego, the mutual fund. ETFs buy and sell securities less frequently than mutual funds, which means they realize fewer gains and thus pay far less in capital gains tax.
There are two reasons for ETFs’ lower trading activity. First, ETFs are generally index funds, which means that they buy and sell securities less frequently than an actively managed mutual fund. ETFs buy and sell mostly to rebalance the portfolio or to reflect any changes in the underlying index.
Secondly, the structure of an ETF is fundamentally different than that of a mutual fund. When an investor redeems mutual fund shares, the fund must sell securities to raise the cash to pay the investor. ETFs trade on the secondary market, where buying and selling has no effect on the securities in the fund. Even if an institutional investor purchases enough shares to redeem them from the fund, the investor receives the underlying securities rather than cash, so no taxable transaction takes place.
Taking advantage of opportunities to lower tax obligations is especially important for long-term investors, since the effects can be compounded over many years. Looking beyond the basics and gaining a true understanding of where tax liability is incurred in an investment can make you a more efficient – not to mention wealthier – investor.
IRAs, or Individual Retirement Arrangements, are important retirement savings vehicles. IRAs offer the potential for tax-advantaged saving, which is especially important for anyone without access to an employer-sponsored retirement plan.
In order to make IRAs easier to grasp, think of a book with a cover. The underlying investment is the book, while the IRA is the cover. The cover tells whoever looks at it what you would like them to know about the book inside, but it doesn’t change the book itself. In the case of investing, the cover is usually related to taxes. The type of “cover” you put on your investment tells the IRS how to treat it for tax purposes.
In an IRA, the “book” can be almost anything – the IRS excludes only collectibles and life insurance. Common choices are mutual funds, ETFs, stocks, or bonds. However, trustees are not required to offer every option, and your options will be limited to those offered by the institution you choose to invest with.
Anyone with income can invest in a Traditional IRA. Contributions to a Traditional IRA are tax-deductible, up to the limit set by the IRS. (For 2015, those limits are $5,500; $6,500 if you’re over age 50).
Qualified distributions from a Traditional IRA, are taxed as ordinary income, but money taken out before age 59 ½ will be subject to an additional 10% penalty on the full amount of the distribution. Traditional IRAs are also subject to RMDs, or Required Minimum Distributions, beginning at age 70 ½.
Depending on your income, your deduction limit may be lower if you or your spouse is covered by an employer retirement plan. For example, in 2015, a single person who is covered by an employer plan is eligible for a reduced deduction when income reaches $60,000, and no deduction at all once income reaches $70,000.
The other type of IRA most people are familiar with is the Roth. Unlike Traditional IRAs, you may be not be able to contribute to a Roth IRA if your income is too high. You are eligible to contribute to a Roth IRA in 2015 if you are a single person making less than $131,000, or a married couple filing jointly making less than $193,000. (As you get close to the income limits, the deduction allowed begins to go down, so check the IRS website to determine your own eligibility.)
Contributions to a Roth IRA are made with after-tax dollars, and qualified distributions are tax-free. Additionally, contributions can generally be withdrawn without penalty at any time, which makes a Roth IRA more flexible than other retirement savings options. Earnings withdrawn before age 59 ½ are generally subject to income tax and a 10% penalty.
Unlike Traditional IRAs, Roth IRAs are not subject to distribution requirements during the lifetime of the account owner.
Additional Notes on Contributions and Distributions
There are a few other things to consider when looking at IRAs.
- The limit of $5,500 ($6,500 for age 50+) for IRAs applies to both Traditional and Roth IRAs, so if you contribute to both in the same year, your total IRA contribution cannot exceed the limit.
- IRA contributions made before April 15th may be allocated to the previous tax year. This can be especially important for those with variable income, if income is higher than anticipated in the first part of a given year.
- If you exceed your contribution limit in either type of IRA, the excess amount will be subject to a 6% tax, so be sure to keep track.
- There are circumstances where a qualified withdrawal may be taken before age 59 ½. These include, but are not limited to, certain medical expenses and the purchase of a first home.
Making the right choice
We’ve gone over some of the basics of Traditional and Roth IRAs, but making the choice can be a bit more complicated. As with all financial decisions, it’s best to deal with actual numbers. Use your current income, tax bracket, and assumed investment returns to perform a simple calculation. If that’s not your cup of tea, anticipate another post from me on this subject, where we’ll dive in to specific examples to help you determine the best course of action.
It’s easy to feel inadequate when it comes to your retirement savings, especially since there is no lack of motivation to make you feel that way. Bloggers like me get to sound smart when we scare you with what is essentially basic math; investment companies get to come to your rescue with savings vehicles; and there is, of course, the inconvenient truth that many of us are lacking in actual savings.
This is not the normal sort of thing you’ll hear from me on this site, but I think it bears mentioning. Investing is a great thing, as long as you have the rest of your financial house in order.
The Set Up
It goes something like this: Responsible Rex graduates college with about $2 in student debt and begins saving 50% of his $80,000 starting salary, while Flighty Fran waits until she turns 50 to start saving 5% of her $30,000 salary. Responsible Rex retires with billions at 55, while Fran retires at 92 and moves into Rex’s basement (which he is renting out for extra retirement income so he can afford a nicer yacht.)
Some of us want to be Rex and others are afraid of being Fran, but either way, we swallow the story hook, line, and sinker and scramble to increase our retirement savings contribution and make it our number one priority. In the process, we may neglect the more foundational areas of personal finance.
Obvious Fact: Saving is Important
I write about investments, so (as you might imagine) I’m a huge fan of Retirement Saving. I would let Retirement Saving autograph my shirt at a concert, an honor previously reserved only for Bruce Springsteen (who has not yet taken me up on it, but I am persistent.) But the blazing neon sign of Retirement Saving can blind us to less visible figures like Budget and Emergency Fund, or even Retirement Saving’s archenemy, Consumer Debt.
I am not a fan of being scared into doing anything, no matter how inherently sensible it seems. It isn’t necessarily smart to rush headlong into Investment Land if you haven’t spent enough time in the Kingdom of Basic Needs. Don’t be so worried about tomorrow that you fail to take care of today.
The Pyramid of Financial Needs
Arguably, the most common visual for the hierarchy of financial needs is a pyramid (because pyramids are structurally hierarchical. It makes sense.) The base of the pyramid is cash management.
Quite simply, cash is first because it will determine your success at every other level of the pyramid. It’s impressive to be saving 30% of your income for retirement. It is less so if you’re racking up debt at the same pace. For some of us, keeping this level in order comes naturally, but most of us have to work at it. If you are in the former category, try to keep the smugness to a minimum. It’s annoying. If you are in the latter, accept it and move on. There are worse things in life.
Most immediately, successful cash management means that you have the funds to protect yourself from risk. When most of us think of risk, we immediately think of insurance. And there is definitely insurance at this level – life, health, disability, property, and casualty insurance are some major categories, with additional liability for some of us if circumstances warrant. Another piece I put at this level is your emergency fund. (Others may argue that the emergency fund belongs with cash. I’m fine with that as long as you have one.)
Once you’ve put a harness on your spending and protected yourself from the unexpected, you are ready to begin saving for your future.
Now that I’ve laid out this neat, logical plan, I’m going to mess it up with a few exceptions to the general order of things. First is 401(k). Responsible Rex may be annoying, but he’s not entirely misguided. If your employer offers a 401(k), go ahead and sign up. If your employer matches your contributions, then contribute at least to the match. Why? Because it’s FREE MONEY.
Another area where you might consider jumping levels is life insurance, if you have dependents who will not be able to fend for themselves in the event of your demise. None of us is guaranteed tomorrow, so regardless of where you are on your climb, make life insurance a priority.
Today vs. Tomorrow
To quote a character from my daughter’s current favorite movie (and the inspiration for this particular post), Seymour S. Sassafrass, “It’s important to dream about tomorrow, but you have to take care of today. It’s a classic today/tomorrow problem.”
Your wedding ranks up there as one of the most important days of your life, so it’s worth splurging on. However, it’s not uncommon for weddings to cost as much as a college education these days. Between the venue, catering, flower arrangements, photography, and dress, the little things quickly add up. So how do you plan the day of your dreams on a budget, without it feeling cheap? It’s all in the details. Keep these handy tips in mind as you start planning.
Image Source: Pixabay
- Carefully curate your guest list.
It’s only natural that you want to shout your love from the rooftops and celebrate it with several hundred of your best friends and distant relatives. But remember: the bigger the wedding, the bigger the bill. Don’t give in to feelings of obligation. If you want to keep your wedding small and intimate, do so without guilt!
- Have an outdoor wedding.
For most weddings, the largest cost will be the venue. If you do decide to rent out that elegant mansion, plan your wedding in an off-season when rates are lower. Otherwise, consider using nature’s own elegant backdrops. Public parks, beaches, or even your own backyard could provide scenic views for exchanging vows.
- Arrange your own catering.
After sorting out the venue, catering is usually the next biggest expense for a wedding. This can be tricky if you’ve shelled out for a proper venue, because they may have their own onsite catering that you’ll then also need to pay for. If you’re able to, try arranging your own catering. This will nearly always be cheaper, and allows you to either ask your own family for help or use a smaller, family-owned restaurant. Smaller restaurants are usually willing to work with you on a great rate, because catering weddings is great publicity for them as well. This way, you can still provide a meal to remember at a price you can afford.
Bringing your own beer and wine can keep costs down as well. Ask your venue about corkage fees first though! If you provide your own booze, shop around to find the best prices and buy in bulk for discounts. Don’t provide an open bar if you can’t afford it – cash bars are perfectly reasonable.
- Use friend or student photographers and musicians.
Do you have talented friends? Ask them about providing musical entertainment and photography duties. Another option to cut costs is to turn to your local art school. Student musicians and photographers trying to build their portfolio will be happy to work for lower rates. Just be sure to look carefully at their existing work first to be sure you’ll be happy with the quality.
- Shop early for clothing and accessories.
Tuxedos, bridesmaid dresses, and rings are all areas that you don’t want to skimp on. This is one day when you definitely want to look and feel your best! But shopping early and hunting with an eagle eye for sales can save you cash. Browse online on sites like Vashi for engagement rings to get a feel for prices in advance. For tuxedos, try renting them for the full wedding party together to take advantage of group discounts. When it comes to the dress, keep an eye out for sales and don’t overlook department store ranges which can rival designers in terms of quality. Vintage and charity shops may also be worth a look for all of the above – you may luck out!
A secured loan has some type of security attached to it. This means that if you default on your loan, the lender can take possession of this security and sell it to cover their costs. As such, a mortgage is a type of secured loan.
People take out these types of loans for a variety of reasons. You may, for instance, want to lend quite a high amount of money. Perhaps you want to improve your property, consolidate your debt or more. Alternatively, you may have a poor credit history, in which case secured loans are the only option out there for you. Because you offer a lender security, they will be more forgiving of your credit history.
How Can You Get a Secured Loan?
You don’t have to be an outright home owner for a secured loan. If you want to secure it against your property, however, you do have to have equity against which you want to secure it. Alternatively, you can apply for different types of secured loans that have been specifically designed to help people in a financial emergency who also have bad credit. These all tend to be low amount loans with high interest rates, but very short running times, generally one month. Let’s take a look at some of these options.
With a pawn loan, you hand over an item of value to a pawnbroker. This could be a piece of jewelry, an expensive item of clothing, something electronic and so on. The pawnbroker determines the value of your item and pays you this, and you then have a set amount of time to pay that back, with interest. If you do not pay it back, the pawnbroker becomes the new owner of your item and will then sell it in their shop.
With payday loans, you secure a loan against your next payday. This means that when you get paid, the lender will automatically take the loan principle and interest out of your account. Generally speaking, you will not be able to lend more than 50% of your monthly income, as the lenders need to be careful that you are able to meet your various financial obligations in the month that you pay your loan back as well.
Title loans are loans secured against your vehicle. This means that you have to have a clean deed on a vehicle in order to apply. The lender will determine the value of your car and lend you money against the value. Usually, the maximum they will lend you is 50% of the value of your car, up to a maximum of $2,000, although there are exceptions. This loan is designed to run for one month, at which point you pay back the loan principle and the interest.
As you can see, there are numerous different secured loan constructions out there to consider. You must always first think whether there is any way to meet your obligations without borrowing money, however.