MONEY Master the Game: 7 Simple Steps to Financial Freedom (55 page)

So if you think you can time the markets, you’re wrong.
Even the best in the world can’t do it every time because there will always be factors they can’t predict. Like stock picking, it’s best to leave market timing to the masterminds who employ large staffs of analysts—ones like Paul, who can also afford to be wrong because of the many different bets they place on the direction of the markets. But this does not mean you can’t take advantage of the
concept
behind market timing—the opportunities of rising and falling markets—by applying a couple of simple but powerful principles that you’re about to learn here. Both involve taking yourself out of the picture and automating your investment schedule. “You can’t control the market, but you can control what you pay,” Burt Malkiel told me. “You have to try to get yourself on automatic pilot so your emotions don’t kill you.”

Far more money has been lost by investors preparing for corrections, or trying to anticipate corrections, than has been lost in corrections themselves.

—PETER LYNCH

SO WHAT’S AN ANSWER TO THE DILEMMA OF TIMING?

One of these techniques is as old as Warren Buffett’s original teacher,
Benjamin Graham,
the dean of modern investing. Graham, who taught at Columbia Business School in the mid–20th century, championed a gutsy technique with a boring name:
dollar-cost averaging.
(In fact, Buffett credits Graham with first coming up with the famous top rule of investing: “Don’t lose money!”) It’s a system designed to reduce your chances of making the big investment mistakes we all fear: buying something right before it drops in price, or pulling out of an investment right before its price goes up.

We’ve already learned the first two keys of asset allocation: diversify across
asset classes
and diversify across
markets.
But remember, there’s a third key:
diversify across
time.
And that’s what dollar-cost averaging does for you.
Think of it as the way you activate your asset allocation plan.
Asset allocation is the theory; dollar-cost averaging is how you execute it.
It’s how you avoid letting your emotions screw up the great asset allocation plan you’ve just put together by either delaying investing—because you think the market’s too high and you hope it will drop before you get in—or by ignoring or selling off the funds that aren’t producing great returns at the moment.

According to the many fans of dollar-cost averaging—and that includes powerhouses like Jack Bogle and Burt Malkiel—it’s the key to sleeping better at night, knowing your investments will not only survive unstable markets but also continue to grow in the long term, no matter what the economic conditions. Sound great? All you need to do is make equal contributions to all of your investments on a set time schedule, either monthly or quarterly.

Easy, right?

But there are two challenges I have to warn you about. First, dollar-cost
averaging is going to seem counterintuitive, and you might feel like you’re going to be making less money using it. But I’ll show in just a moment that what’s counterintuitive is actually to your advantage.
Remember, the goal is to take emotion out of investing because emotion is what so often destroys investing success,
whether it’s greed or fear. Second, there’s been some recent debate about the long-term effectiveness of dollar-cost averaging, and I’ll show what both sides are saying. But first, let’s talk about the most common way investors use it and its potential impact.

When you invest on a set schedule, with the same amount of money invested each month or week in exact accordance with your asset allocation plan, the fluctuations of the market work to
increase
your gains, not decrease them.
If you have $1,000 to invest each month, and you have a 60% Risk/Growth and 40% Security asset allocation, you’re going to put $600 in your Risk/Growth Bucket and $400 in your Security Bucket regardless of what’s happened to prices.
Volatility through time can become your friend.
This part might seem counterintuitive. But Burt Malkiel gave me a great example of how it works:

Here’s a great test. Take a moment and give me your best answer to this question:
Suppose you’re putting $1,000 a year into an index fund for five years. Which of these two indexes do you think would be better for you?

Example 1

• The index stays at
$100
per share for the first year.

• It goes down to
$60
the next year.

• It stays at
$60
the third year.

• Then in the fourth year, it shoots up to
$140.

• In the fifth year, it ends up at
$100,
the same place where you started.

Example 2

• The market is at
$100
the first year.

• 
$110
the second year.

• 
$120
the third.

• 
$130
the fourth, and

• 
$140
the fifth year.

So, which index do you think ends up making you the
most
money after five years?
Your instincts might tell you that you’d do better in the second scenario, with steady gains, but you’d be wrong. You can actually make higher returns by investing regularly in a volatile stock market.

Think about it for a moment: in example 1, by investing the same amount of dollars, you actually get to buy
more
shares when the index was cheaper at $60, so you owned more of the market when the price went back up!

Here’s Burt Malkiel’s chart that shows how it happens:

After five years of a steadily rising market, your $5,000 turns into $5,915. Not bad.

But in that volatile market, you make
14.5% more in profit,
winding up with $6,048! The problem, Malkiel told me, is that most people don’t let the first scenario work for them. “When the market falls, they say, ‘Oh my God! I’m going to sell!’ So you have to keep your head and keep a steady course.”

Investors learned a hard lesson during the first ten years of the 2000s, or what’s known in financial circles as the lost decade. If you put all your money into the US stock market at the beginning of 2000, you got killed.
One dollar invested in the S&P 500 on December 31, 1999, was worth 90 cents by the end of 2009.
But according to Burt Malkiel,
if you had spread out your investments through dollar-cost averaging during the same time period, you would have made money!

Malkiel authored a
Wall Street Journal
article titled “ ‘Buy and Hold’ Is Still a Winner,” in which he explained that if you were diversified among a basket of index funds, including US stocks, foreign stocks, and
emerging-market
stocks, bonds, and real estate, between the beginning of 2000 and the end of 2009, a $100,000 initial investment would have grown to $191,859. That’s over 6.7% annually during a lost decade.

“Dollar-cost averaging is how you make the volatility of the market work for you,” he told me.

Everyone from Warren Buffett’s mentor Benjamin Graham to Burt Malkiel and many of the most respected academics certainly make a case for using dollar-cost averaging when you’re investing a percentage of your steady stream of income. But if you have a lump sum to invest, it may not be the best approach. If this is your current situation, read the breakout box in this chapter titled “Dollar-Cost Averaging Versus Lump-Sum Investing.”

What dollar-cost averaging really means is systematically putting the same amount of money across your full portfolio—not just the stock portion.

Remember, volatility can be your friend with dollar-cost averaging, and it can also allow for another technique that will keep you on track, “rebalancing,” which we’ll address in a moment.

So what’s the best way to put dollar-cost averaging to work for you? Luckily, most people who have 401(k)s or 403(b)s that automatically invest the same amount on a fixed time schedule already reap the benefits of dollar-cost averaging. But if you don’t have an automated system, it’s easy to set one up. I have a self-employed friend who set up her own tax-advantaged retirement account with Vanguard, and she’s instructed it to automatically deduct $1,000 from her bank account every month to distribute among her diversified index funds. She knows she might not always have the discipline to buy when one market feels too high or another drops too low, so she takes herself out of the picture. She’s a long-term investor who doesn’t
worry about timing anymore, because her system is automated, and the decision is out of her hands.

There’s a way to make dollar-cost averaging even easier, and that’s by setting up an account with Stronghold, where it will do this for you automatically.

Also, remember, in the next section I’ll show you an extraordinary tool that can protect you from losing your principal in these volatile times. Where, even if your timing is all wrong, you don’t lose a dime in the stock market. And if you’re right, you win even bigger. But before we get there, let’s have a look at a second time-tested
pattern of investing
that will protect your savings and help you maximize your Freedom Fund as you build true wealth.

THE PATTERN TO AVOID: THE AVERAGE PERSON’S APPROACH TO INVESTING! A REBALANCING ACT

David Swensen and Burt Malkiel sometimes take different approaches to finance. But there’s one lesson they both told me, and all the other experts I’ve interviewed agree on this:
to be a successful investor, you need to rebalance your portfolio at regular intervals.

You have to take a look at your buckets and make sure your asset allocations are still in the right ratio. From time to time, a particular part of one of your buckets may grow significantly and disproportionally to the rest of your portfolio and throw you out of balance.

Say you started out with 60% of your money in your Risk/Growth Bucket and 40% of your money in your Security Bucket. Six months later, you check your account balances and find out that your Risk/Growth investments have taken off, and they no longer represent 60% of your total assets—it’s more like 75%. And now your Security Bucket holds only 25% instead of 40%. You need to rebalance!

Like dollar-cost averaging, rebalancing is a technique that seems simple at first, but it can take a lot of discipline. And unless you remember how important and effective rebalancing is in maximizing your profits and protecting against your losses, you’ll find yourself getting caught up in the
momentum of what seems to be working in the moment. You’ll be hypnotized into the illusion that your current investment successes will continue forever, or that the current market (stock market, real estate market, bond market, commodity market) can go only in one direction: up.

This pattern of emotion and psychology is what causes people to stay with an investment too long and end up losing the very gains they were so proud of originally. It takes discipline to sell something when it’s still growing and invest that money into something that’s down in price or growing more slowly, but this willpower is what makes someone a great investor.

A powerful example of this principle was the day I was visiting with investment icon
Carl Icahn.
It was just announced that he had made a profit of nearly $800 million on his
Netflix
stocks. He’d bought the majority of his shares at $58 the previous year and was now selling them for $341 a share. His son, Brett, who works with Carl and who originally brought this investment opportunity to him, protested the selling of the stock. He was certain that Netflix had more growth ahead of it. Carl said he agreed, but their portfolio needed to be rebalanced. If they didn’t rebalance, they could find themselves losing some of the extraordinary profits that they gained. Carl took his 487% profit and reinvested those profits into other assets in his portfolio, while keeping 2% of his Netflix shares to take advantage of any potential growth. Some of that money he used to buy $2.38 trillion in a little company called Apple, which he believed was undervalued at the time. He sold high and bought low. And rebalancing was a key part of that process.

IF BILLIONAIRES DO IT, MAYBE YOU SHOULD TOO!

So what do you do if you find that you’re out of balance? You were 60% Risk/Growth and 40% Security, but as we described above, your stocks have soared, and you’re now 75%/25% as a result. In this case, your rebalancing action plan requires you to shift your regular contributions to the Risk/Growth Bucket into Security until the 25% is back up to 40%. Or you have to divert the profits or even sell some of the Growth/Risk investments that are booming and reinvest them back into bonds or first trust deeds or whatever combination of assets you’re keeping in your Security Bucket. But this
can be agonizing, especially if, say, REITs are roaring, or international stocks are suddenly going through the roof. Who wants to jump off when you’re riding a rocket? All you want is more! But you have to take some of those assets off the table to reduce your exposure to risk and make certain that you keep some of the gains or profits you’ve made.