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by Matt Frankel, CFP® | Updated July 21, 2021 - First published on Feb. 18, 2019
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Here’s one of the smartest things investors can do to improve their chances of long-term success.Image source: Getty Images.
When first-time investors ask for my advice when they're opening a brokerage account or starting their first IRA, one of the most important pieces of advice I give is to automate the contribution process.
In other words, instead of just telling yourself that you'll put $200 into your brokerage account every payday or assuming you'll just invest whenever you have the extra cash, set up an automatic transfer from your bank account at a set interval -- immediately after every payday makes the most sense.
Of course, there are a lot of other factors to think about when investing. For example, how do you know what stocks or funds to invest in? How much should you invest in stocks and how much in bonds? Questions like this are quite meaningless if you don't have money in your brokerage account, and automating the process ensures that won't be an issue.
There are two main reasons why automating your investing is so important. First is that it forces you to stick with your plan.
For example, let's say that you want to invest $200 out of every paycheck. It's quite common for people who plan to do this sort of thing to forget to make the transfer after payday, or to give up entirely after a couple months. To be honest, I've done it. On the other hand, if you set an automatic transfer, it becomes part of your financial routine, and you'll be surprised at how quickly you get used to it and stop thinking of your investment contributions as optional.
Second, automating your investment contributions allows you to naturally take advantage of stock market drops, like the one we saw towards the end of 2018. This principle is known as dollar-cost averaging and allows you to guarantee yourself a mathematically favorable investment cost.
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Consider this simplified example. Let's say that you invest $400 in a certain stock each month until you've invested a total of $2,000. We'll say that the share price is $50 the first month, $40 the second, $50 the third, and then it shoots up to $80 the fourth month. So, your investments would look like this:
|Month||Shares purchased for $500||Price per share|
Data source: Author's own calculations.
Two key takeaways. First, if you had waited until you had $2,000 to invest, you would have paid $80 for all of your shares. Second, the average stock price between these four dates is $54. This strategy allowed you to buy more of your shares while the price was low, and fewer when it was high.
You may be thinking, "Why not just buy all of your shares when it was $40?" I agree, that would be great. It would also be great if I could pick tonight's winning lottery numbers. There's no way to know when a stock is at its cheapest. However, investing a set dollar amount at regular time intervals allows you to put the odds even more in your favor from a long-term perspective.
As a final piece of advice, be sure to only commit to an automatic transfer that you'll be able to afford in perpetuity. In other words, if you have exactly $500 available from each paycheck after your living expenses are paid, don't set an auto-debit for that entire amount -- doing so is just asking for failure. Instead, set your automatic investment to an amount that you can comfortably afford. If you then decide to invest more beyond that, go for it.
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