Monday, May 12, 2008

Retirement Planning - B is for Balance

As we continue our alphabetical look at the wide variety of investment terms that are thrown about - in such a way as to generally assume you know what is being spoken or written - we will look at balance.

B is for Balance

There has been entirely too much emphasis placed on the need for balance. I firmly believe that in order for each part of your plan to work, it needs to have time to develop. Few people are willing to ride market unrest out, constantly tweaking their portfolio of mutual funds to get the same return, quarter over quarter, year over year.

Not only is this difficult for professional money managers, it is nearly impossible for the average investor to do.

There are far more important things to “waste” our time doing. If you follow some basic rules, you will be fine.

Ask The Right Questions

Among the first things you should ask yourself is “why did I buy this fund?” If it was because you found the long-term returns to be in line with your goals, then let the fund manager work out any kinks the market might throw his/her way. Check the fund each quarter but focus on the yearly prospectus. You should also keep those dollars invested. A down market is a buying opportunity for investors who use dollar cost averaging.

What is DCA?

Dollar cost averaging or DCA is one of the single most important ways to build a retirement portfolio. The method invests money each month directed to your defined contribution plan in equal amounts. This allows you to buy more shares of your mutual fund when the price is low and less when the price is high. It employs one of the basic market principles better than most investors would and does it with no effort.

There are several reasons that this works. Suppose the mutual fund you purchased was selling shares for $5. For each $5 you invested, you received a share in the fund. The market, doing what it does best changes based on an innumerable amount of factors. In some instances, this makes the share appreciate, increasing the price and in others, the price goes down.

When the price increases to $7, your designated investment dollars does not see that as a buying opportunity. Your five dollars instead buys only a portion of a share, in this case, only about three quarter of a share. In this instance, it keeps you from buying shares that might be overpriced.

But if the market goes down and the share price decreases to $2.50, your five-dollar investment has bought a share and a half. Investors have a difficult time controlling the desire to buy more when the markets are on the way up and selling when they are declining in value. DCA solves this.

In your Retirement Plan

The idea behind it is simple and is employed with great success in your company-sponsored plan. In those plans, money is automatically taken from your paycheck. If you are using a traditional 401(k), it is done before taxes are taken from your paycheck. If you are participating in a Roth 401(k) it is taken from after-tax dollars.

In both plans, a steady stream of cash is invested for your future. IRA users have some different challenges facing their use of DCA to its best advantage. Often, IRA investors opt for sending their mutual funds a check each month. This allows them to act based on current headlines.

If this sounds like something you are doing, set-up your contribution to be done automatically and write that amount in your budget. This will give you the opportunity to take advantage of all of the magic the DCA offers.

Previously: A is for Asset Allocation

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