Oh go on, one more investment related step before we end the series on investing… Despite its very boring name, dollar cost averaging is a powerful investment strategy that actually makes market volatility work in your advantage.
This is achieved in two ways:
When the market is up you buy less shares, thereby avoiding investing a lot of money when shares are overpriced and when a crash might be just around the corner;
When the market is down, you benefit by buying more shares, thereby making the most of the shares being “on sale”.
Let’s look at how dollar cost averaging works.There are generally two ways to invest: investing a lump sum or investing a set monthly amount. As we know markets go up and downs all the time and although most markets go up over time, they still experience periods when prices drop.
Lump sum investing
Imagine you have a windfall of say $10,000 that you want to invest. If you invest it all in one go at a time when the market is climbing, this might be a very poor moment to invest this money. Wait a few months and the market might well experience a downturn:
Say the average price of shares at the moment is $100 then (costs excluding) you’d get 100 shares for your $10,000.
Imagine the prices drop to $80 on average in the next 6 months. If you had held off investing for 6 months, you would have been able to buy 125 shares, i.e. 25% more!
Now let’s say that another 6 months later the price of shares is back up to $100 a share again. If you entered the market today, you would have gained nor lost anything in a year’s time. Had you entered the market when shares were only $80 a piece, your portfolio would be worth $12,500 in a year’s time.
In the previous step we looked at how investing in Real Estate can be an interesting addition to your portfolio in order to spread your risk more and generate another new income field. In this step we will look at another way to diversify your investment portfolio which is through commodities and gold.
Investing in commodities
Commodities (or natural resources) are important for the stock market in two ways: firstly many companies rely on commodities. If you have any Coca Cola shares then of course sugar prices at some point affect Coca Cola profit and therefore share and dividend prices. For any shares you might have in big retail or fashion stores wool prices will affect these share prices at some point in the chain and many other companies might rely on such commodities as oil, copper, grains and aluminum.
Apart from their importance to the companies that trade on the market, commodities play another part on the market as they too can be invested in directly, just like shares and bonds!
There are generally two commodity classes:
Soft commodities – cocoa, wool, cotton, wheat, rice, coffee etc. These prices can fluctuate a lot, especially when a shortage exists (think about a bad harvest for grains, rice, potatoes or coffee for example and how this can drive up prices). Apart from the weather, also a growing population as well as people’s eating patterns effect these prices.
Metals – zinc, aluminum, copper. Prices are less volatile as their time takes much longer: a new mine takes much longer to open and operate. It’s easier to predict how prices are affected, also if new technologies such as microchips are developed that require more or different metals.
We’ve looked at investing in the stock market in detail and how stocks and bonds offer the opportunity to create and maintain wealth over time (but remember that investing in the market always has the risk of losing a lot of your money too…). In order to spread risk when investing in the market, creating a balanced portfolio is generally the recommended way to go, in which your money is divided over many different companies, industries and markets and investing opportunities.
Whereas many investors have big chunks of their money (if not all) invested in a mix of bonds and shares, there are also other investment options to consider in addition to stocks and bonds that offer an extra diversification to your portfolio. In this step we’ll discuss one common alternative or addition: real estate, whereas the next step looks at investing in gold (and precious metals) as well as commodities to complement investment portfolios.
Investing in Real Estate
We have of course already discussed the option of buying another property and renting it out to a tenant as a way to invest your money in order to generate an additional income stream as well as the possibility of a capital gain on the estate itself in the long-term. This is one way of investing in real estate, but there are other market options to invest in real estate, including:
REITs – Real Estate Investment Trusts – similar to a mutual fund, REITs trade on the market. A trust pools together investors’ money in order to purchase real estate and rent it out to generate income. The advantage of REITs is that they must pay out a big chuck of their profits as dividend in order to keep their status as a REIT, meaning that returns can be very interesting. You of course don’t own the property but own a part (like a share) in the trusts’ property portfolio. Like stocks and bonds you can sell your part to other investors and REITs go up and down in price similar to the rest of the market.
Real Estate Investment Group – This option is ideal if you want to actually own another property to rent out but don’t want to deal with the hassle that comes with it: finding tenants, collecting rent, dealing with maintenance issues etc. As an investor in a real estate investment group you buy one or more units or flats of a bigger apartment complex owned by an investing company. By buying a unit, you become part of the Real Estate Investment Group and become the owner of the flat, but the investing company will deal with all the day-to-day issues and operating of the units on a collective basis. They will take a part of the rent you generate so you still profit from renting out your property, but you have very little to do with the day-to-day operating.
Real estate trading – Also known as Flipping, this is a practice in which somebody buys a property, hold it for just a short amount of time, usually only a few months and then sell it again at a higher price. This is especially effective if one is able to buy a property in a hot spot or if one acquires a building that is highly undervalued and therefore a bargain to buy and then sell again. This is a different way of investing in real estate and contrary to capital gains over a long period of time, real estate trading is focused on capital gains made in just a few months. Bear in mind that taxes on short-term capital gains can be significantly higher though.
Investing in real estate can be housing, but can also include other types of real estate such as commercial property (think about offices and factories) as well as old age pensioner’s homes for which demands are increasing all the time due to aging populations.
Let’s look at one more pension option before we round off the pension series: Annuities. Sounds like something complex (and they certainly can be when they want to be!) but this step will break down their characteristics and benefits, as well as some of their disadvantages.
What are annuities?
Annuities are a financial product somewhere between an insurance and an investment option. Like any insurance, you buy annuities – in this case it insures you against living too long. Yes, you read that right. Whereas a life insurance insures against dying too early, an annuity insures you against living too long. An annuity provides a set monthly income that you get for the rest of your life after a certain age. If you are fearful that you might outlive your pension, i.e. that you might withdraw too much from your investment and / or pension fund and end up without any money at some point in your retirement, an annuity is a good solution as it gives you a guaranteed monthly income.
How do annuities work?
There are many different types of annuities with many different characteristics. First of you normally buy an annuity from an insurance company, pension provider or broker who then reinvests your money. It very much works like a mutual fund and the company you buy the annuity from will add in a profit margin of course so your money won’t grow very much over time due to the fees you pay. You can buy an annuity with all of your pension savings just before you retire or you can buy several smaller annuities over time. Annuities differ in the way that they are set up and some of the key variables include: Continue reading →
A difficult question that many people on their mission to financial independence quickly encounter is “where they should get their money to work for them”: You’ve managed to cut down a little on your expenses, or to up your income or earnings from a side hustle. But the question as to what to do with the extra money you now have remains. Let’s review some of the avenues on how to “make money with your money” that we have looked at on this mission:
Paying off debt – saves you money on interest and compounded interested paid over the years.
Saving – generates money due to interest received and the power of compounding interest over the years.
Investing – generates money due to capital gains, interest received or dividends.
Pensions – builds up the income you’ll receive after your retirement age
Personal capital – increases your earning potential as a professional or entrepreneur.
These are the most common strategies to pursue in order to leverage what your money can do for you.
But where to start? Say you saved $100 this month and that you are happy to invest this money into your future and future earnings, where do you actually put this money? Which of the above options do you choose? And how do you mix these strategies?
If you haven’t yet fully read the previous steps on the above mentioned strategies, I invite you to read those first before continuing reading this step, to better understand all the pros and cons of each strategy. Just come back once you’re done!
The question of where to allocate your money doesn’t have to imply an “either …or…” situation. You can start investing whilst still having a mortgage. You’ll want to save an emergency fund together whilst still paying off credit card debt. And once you start investing in your personal capital, you’ll likely want to keep that up on a fairly regular basis and the fact that you are investing in the market doesn’t rule out this option. Continue reading →
After all these steps on cutting expenses, building up savings and investing to build a pension, it can become easy to dismiss any investing in yourself at all, especially in your intellectual abilities as a professional.
You might have got to a point where you’ve got all your daily costs taken care of: you’ve got a good, solid budget that you are happy with and able to stick to, you have short-term savings goals set up that you contribute to monthly such as a holiday or a new laptop and you even have your long-term savings on track in the form of pensions, paying off your mortgage and / or investing in the stock market.
When you get to this point it becomes easy to get completely taken up by this popular personal finance motto:
Earn more, reduce your spending, invest the difference.
And whilst there is nothing wrong on paper with the above guideline, it is easy to get a little too distracted by this, to become too frugal and forget what else is important in life. In step 75 we looked at how spending a little on yourself every now and again is important to not forget the importance of “YOU” and to make space in your budget to reward or treat yourself.
But what about your intellectual or professional development? When you get too sucked up by financial independence, be careful not to overlook the importance of individual capital and the need to invest in this aspect of yourself, over putting the money into more investing or savings. Continue reading →
“Pay Yourself First”, one of the biggest motto’s in the personal finance world, is a hugely empowering and motivating concept that stimulates you to keep your savings goals at the top of your list. It’s origins are attributed to George Clason’s famous book The Richest Man in Babylon and although the book is nearly a century old, many of its lessons are still extremely valuable today.
I can hear objections already “But I am not a business owner, I can’t pay myself”, or maybe you do own your own company and think: “I need to pay my people first before I can pay myself”. Then yes you are totally right in both cases. But that is not what this concept is about.
Pay yourself first has nothing to do with your salary. It has all to do with priorities. You can be on a regular pay roll and get paid by your boss but still pay yourself first. Or you can be a business owner and pay your employees before anybody else, then pay all your creditors but still pay yourself first.
Pay yourself first has everything to do with setting priorities for your finances. Let’s complete a mental exercise about the road that your money takes every month. It of course starts with pay-day: you receive your paycheck. The first thing that happens even before you receive that money are the taxes taken out of it. Then you receive whatever is left over and probably one of the first things you need to pay are the rent or the mortgage. Then there’s the car your paying off, insurance to pay, utility and food bills and you’re in desperate need for a new coat and of course you’re joining your co-workers for a Friday afternoon drink after work. You likely have some more to add. So the list continues until there’s hardly anything left at the end, right?
So let’s see who’s being paid here then, as it certainly wasn’t you!
taxes of course are payments to the state;
rent – there’s your landlord getting paid;
mortgage – that will be your bank manager getting paid;
car payments – another one for your bank manager or car dealer;
insurance – the insurance company will have that, thank you very much!
water and electricity bills – your utilities companies cashing in
a new coat – that’s your shop assistant and retailer getting paid.
Friday afternoon drink – the bar owner will happily hold out his hand.
And the list of course goes on and on. So where’s your payment? How do you benefit from the money that you earned? Of course you’re able to buy yourself a shelter over your head with that income by paying off you mortgage or paying rent, but that money is being paid to somebody else. With your pay you are also able to buy food and clothes and security in the form of insurance, but whilst you are purchasing these items, somebody else is also benefiting from you buying these products: they are getting paid by you. The one person who doesn’t seem to be being paid is YOU.
Now it would be ridiculous to say that you shouldn’t buy these items and stop paying other people, as you probably wouldn’t survive very long or have a miserable life living at the margins. That’s why this step isn’t called “Stop paying others”. Our society and economy are based on exchanging goods and services for money and it is a key part to survival, happiness and life. Instead “Pay yourself First” encourages you to – before anything else – pay yourself first before you start giving away your money to others.
Although you might not be able to change so much about the fact that taxes are taken out of your pay first (although of course there are some pension funds that will let you invest tax-free and then you could always consider moving to a lower tax state or country), you can pretty much make sure that as soon as you receive your net pay, that you pay yourself first.
How to pay yourself first? By setting aside money for you – to build a secure financial future, to grow your capital and net worth, to reduce debt and to improve your general financial situation, so that you and your family little by little gain more financial security and freedom. By assigning an amount of money to go to you, you give your future self an income, instead of spending it all and giving it away to others, you make sure that some of it comes back to you later.
This means that instead of having to work indefinitely in order to keep up with all of your creditors every single month, you can at some point stop working and enjoy the money you have set aside for your future self. It means that you have paid yourself forward and secured yourself a future income.
Whenever you get paid, think about how to pay yourself first. Set aside money in a savings account, invest the money in a pension fund, or pay down your debt so that you free yourself of those monthly creditor payments. Don’t allow yourself to come up with excuses like: “I don’t make enough” or “my bills are too high”. Find ways to reduce your expenses, to increase your income and remember that starting small is always better than not starting at all. Even small contributions add up over time, and by starting small you build a habit that when you finally reduce those expenses or increase your income, you can instantly increase contributions.
Step 82 – Pay Yourself First – in detail:
Brainstorm a list of how you already pay yourself first. How do you use your money to improve your finances?
Saving money for a specific goal to avoid future debt.
Look at your overview of your fixed, variable and discretionary expenses, go through the list and identify one by one who you are paying every time you make any of these payments. Go through the full exercise and write down the beneficiary for every single expense. See how many people are being paid over you!
Give yourself a score of how well you are doing on a monthly basis out of 10, with 10 being “excellent” and 1 “poor”.
Set yourself a target monthly contribution or grading on how much to pay yourself each month.
Refer to Step 12 which gives a further breakdown on how to set yourself specific savings goals on a practical level.
Once you become familiar with the “Pay yourself first” concept and start internalizing this more, you’ll discover the true power of this wisdom that will keep you focussed on your mission to financial independence.