An Engineering Approach to Money

For a new investor the task of deciding when to invest can be daunting, but I have a secret for you, you can’t time the market wrong when you are starting out, no matter which direction the market is moving you’ll win because of the broad trend upward that the markets always maintain.

But if the market is going down, or going to go down in the short term shouldn’t I wait? If you are certain the markets will be down in the short term then, yes, you should wait. But how can you be certain? I have been at this for 20 years and I’m still constantly surprised by the short term moves of the market.

The trick here is to use dollar cost averaging so that no matter which way the market moves you’ll be a winner. By putting a fixed number of dollars in no matter which way the market is moving you have the advantage of winning if the market is up and winning if the market is down. You can look at movements in both directions as positive for you.

Here is how it works, say you can buy into an total market index fund that invests in all companies and is currently trading at $20 per share and you have $200 a month to invest, the first month you get 10 shares. Now lets look at the two possiblities:

1) Stock goes up $1

In this case during the 2nd month the price is $21 per share (and your original shares are now worth $210). Your $200 now buys only 9.52 shares so you own 19.52 shares worth $410.

2) Stock goes down $1

In this case the price is now $19/share (your original shares are worth $190). BUT your $200 now buys 10.52 shares so you now own 20.52 shares worth $390. So while your investment is, in fact, worth less, you own more shares, so that each upward move over the next 20 years will be with more to you. In 20 years when each share is worth $200 instead of $20 that extra share you got this month is worth another $200.
If the market went up your investments value went up, but if the market falls your value went down, but each new investment buys more shares and so your total number of shares is greater.

Since the total market has a broad upward bias, that is the market always goes up over a long enough time period, if you are planning to be invested for the long haul (the next 20 years or more). Then a short term correction means the broad market just went on sale and by purchasing now you get a bargain price.

By spending the same amount every month you win if the market goes up in the short term, and you win more if the market goes down in the short term. The only way to lose is to not invest your money at all and piss it away on consumer goods which we know will be less tomorrow than they are today.

I just sent off checks for my wife and I to contribute to our Roth IRAs for 2006. I’ve been fully funding our Roth IRAs since they were first introduced about 7 or 8 years ago. For those of you unfamiliar with them they give you no current tax advantage, but the earnings will never be taxed, provided you follow the IRA rules about not taking anything out beyond the principle before your are 59 1/2. You can always take out the money you put in with out any penalty, but the earnings will only be tax free if you use them for retirement.

As with most investment things, to really win big you have to start when you are young. In my case I didn’t get started until I was about 35 or so. But I’ve been fully funding for several years now and between my wife and I we are approaching 70K in our Roth accounts. We are invested in the Vanguard S&P500 index fund, this has traditionally returned about 11% so thats ~7K next year tax free for retirement that will compound year after year to hopefully grow to something substantial over the next 20 years so that when we are finally ready to draw on it will be a big chunk. Let’s see assuming an 11% annual return with a 8,000 annual contribution for the next 10 years that amounts to ~650K in constant 2006 dollars when I reach 65 in 2029 if we’re still throwing off 11% that’s 70K of tax free money (constant 2006 dollars again) every year.

I also have a traditional IRA and non-IRA investments to supplement this so that if things don’t go as well as expected I should still be good. One of the great things about a Roth IRA is that it gives you a 3rd kind of account to draw on. By mixing withdrawls from a traditional IRA, roth IRA, and normally taxed accounts each year we should be able to minimize the pain of taxes eating away at our retirement funds in any given year.

Consider a Roth IRA or a Roth 401K, especially if you have kids as your taxes will go up once you can no longer claim them as deductions. Since my wife doesn’t work and we have 2 kids in grade school and a big home deduction we’re in about the lowest tax bracket we will ever be for our income level, this is the best time to Roth. Once the kids are grown we’ll want all those current tax deferals we can get.