Last week I wrote about how to invest in mutual funds. Today, backing up a bit, I’m going to talk about terms that you hear bouncing around the PF blogosphere, namely, the concepts of “Pay Yourself First”, “Dollar Cost Averaging” and Diversification. This is the first post in a series on how to start investing.
Pay Yourself First
This concept is the most controversial of PF topics — do you save money before paying your expenses or afterwards?
Let me explain. Some bloggers, when they receive a $1000 cheque, will automatically save/invest $200 and live off of the remaining $800. Some people might even organize themselves with their HR departments to have the $200 taken off their paycheque automatically. The argument behind this practice is that, if you don’t see the money, you won’t miss it. Eventually, you’ll “forget” that you actually earn $1000 and will adjust your budget to live comfortably on $800.
Alternatively, some bloggers will take that same $1000, spend, and then save/invest the balance. Personally, I do a mix-match. I auto-contribute to my RRSP every month but save what ever money I have leftover at the end of the month.
Dollar Cost Averaging
Dollar cost averaging is this a theory about why continually investing is better than investing in one big chunk.
Say you have an extra $1000 each week to invest. If you save that money and, in month 4, buy $4000 worth of stocks at $9, you will have 444.44 shares worth $4000.
If you buy stocks each month, the price may fluctuate:
Month 1: $1000 @ $9/share = 111.11 shares
Month 2: $1000 @ $8/share = 125 shares
Month 3: $1000 @ $10/share = 100 shares
Month 4: $1000 @ $9/share = 111.11 shares
In that scenario, at the end of 4 months you will own 447.22 shares at $9/share and your portfolio would be worth $4024.98 or 0.62% higher than a lump sum investment.
Diversification is a must have for any investor. Basically, it means that your money is invested in a bunch of different areas so that, in the event of a market downturn, you don’t lose all of your money.
For example, if I had invested all of my money in RIM (the maker of Blackberries) last week, I would have lost 20% of my money. By investing in many companies and sectors (the general rule is 25 companies and 10 different sectors), I am able to lose money in some areas without being wiped out.
Sectors can include utilities, communications, electronics, media, publishing, banks, technology, cars, clothing, natural energy etc etc etc.