Experienced investors don’t need to be convinced about the inherent volatility of the stock market. Prices seem to soar and plummet regularly. One possible investment strategy for smoothing out the inevitable ups and downs is called “dollar cost averaging.” But this long-standing investment method has as many detractors as proponents.
The basic concept is relatively simple. Essentially, you invest a fixed amount of money in shares of the same stock at regular intervals – usually, on a monthly basis – regardless of the stock’s performance. (The same principle can be applied to investments in mutual funds.) And you continue to invest the same way for an extended period of time.
As a result, you may be able to acquire shares of the stock at a lower cost per share than the prevailing price, providing some volatility protection. This strategy removes the guesswork of trying to “time” the market.
For example, let’s say you decide to invest $100 monthly in Technology Inc. stock. If the stock sells at $20 a share in the first month, you’ll receive five shares. Now assume that the price of the stock drops to $10 a share, so you acquire ten shares in the second month. In the third month, the price of the stock rebounds to $25 a share, giving you four shares.
After three months, you’ve acquired 19 shares of Technology Inc. stock for $300. Your “average cost per share” is $15.79 ($300 divided by 19). But the stock’s average price per share during the same time was $18.33 ($20 + $10 + $25 divided by 3). This averaging effect makes the per-share cost of your investment lower than the average market price per share for the same time period.
On the other hand, there’s no guarantee that dollar cost averaging will work. It doesn’t eliminate the risk of a loss in a declining market or that the average cost per share will move slowly. In fact, if you choose a stock that continues to slide downward, your paper losses could pile up.
Dollar cost averaging requires dedication. Advocates say you must stick with this approach in both good times and bad. That means you can’t stop investing if the market goes into a tailspin. Yet there may come a time when you figure you have to cut your losses.
Dollar-cost averaging is a disciplined investment strategy, but it doesn’t eliminate the need to review your investments periodically to make sure that they still meet your expectations and your risk tolerance.
Savvy investors often spread their risks by investing in a variety of asset classes such as stocks, bonds, commodities, and real estate. But with a changing tax landscape, investors might consider three more classes: taxable, tax-deferred, and tax-free.
In days gone by, taxpayers often worked under the assumption that their tax bracket would be lower after they retire. Therefore, a common strategy was to defer as much taxable income as possible to the golden years. Now, however, with the possibility of higher tax rates in the future, it could be more efficient to pay those taxes today while rates remain lower. Since no one knows for sure what Washington will do, it might be time to hedge your tax risk and allocate your portfolio between accounts with differing tax consequences.
Taxable accounts, such as savings or brokerage accounts, result in current taxation on earnings, but they do provide maximum flexibility. You can withdraw as much as you wish whenever you wish, with no IRS penalties or taxes. Keeping some of your nest egg in this type of account will provide immediate funds for major purchases or debt reduction.
Tax-deferred accounts, such as IRAs or 401(k)s, only postpone the payment of taxes; eventually you will have to pay Uncle Sam when you withdraw the funds. But in the meantime, you generally receive a current-year tax deduction when you contribute, and the account can grow tax-free until you take it out at retirement.
Tax-free accounts, such as Roth IRAs, are funded with after-tax dollars. What you put in, including any investment earnings, can be later withdrawn tax-free. The downside? You generally must wait until after age 59½ (and the account has to be open for five years) to make a tax-free withdrawal.
Diversifying your portfolio is only the first step. The next (and trickiest) step is properly investing in each type. For instance, your goal for a taxable account might be to generate growth while keeping taxable earnings to a minimum. This could be done by investing in tax-exempt municipal bonds or low-dividend yielding growth stocks.
In a tax-deferred account, investment income is not taxed until withdrawn, so earnings can come from any source without immediate tax implications. However, since you must start withdrawing funds from an IRA or 401(k) at age 70 ½, you might want to stay away from highly volatile investments as you approach that age. Your account will have less time to rebound from a down market.
Tax-free Roth IRAs offer the longest time horizon for investing since you are not required to make a withdrawal at any age. So investments with higher risks or lower liquidity might fit best here.
In an era of high uncertainty and low expectations, tax-efficient investing has never been more important. To review the tax implications of your investments, give our office a call today.
A whirlwind of regulatory changes are coming in 2012 for 401(k) plans. If you are a plan sponsor (employer), you should consider the following action items to make sure you stay up to date and are fulfilling your fiduciary responsibilities to the plan.
Benchmark Your Plan - ERISA requires the plan sponsor, as a fiduciary, to ensure that plan expenses for participants are reasonable. The best way to document your fulfillment of this obligation is to have an independent third party prepare a benchmarking study. The study should include a comparison of all fees, investment diversification and performance parameters (contribution rates, participation rate, utilization rate etc.) to those of similar plans based on total assets, number of participants, average account size and industry.
Review Your Plan’s Investment Policy - An effective written investment policy can go a long way toward avoiding plan sponsor ERISA liability. An effective investment plan should detail how the plan’s investments are chosen (diversification, performance, cost etc.) and how often they are reviewed and the review procedure.
Prepare for the U.S. Dept. of Labor’s New Regulation on Participant Fee Disclosure - Even though the regulation stipulates that the Plan Administrator (employer) is responsible for compliance, realistically the plan record keeper is going to have to provide this data to plan participants. Ask your record keeper to provide you, in writing, with details of how your plan will comply. Get estimates of what your employees will see on those disclosures and be prepared for their questions. Many will be surprised that there are any costs associated with their 401(k).
Review Your Fiduciary Risk Exposure from Your 401(k) Plan - ERISA bestows on the plan sponsor a fiduciary duty to act in the best interests of the plans participants and to see that the plan is operated for their sole benefit. Many plan providers and consultants provide a fiduciary checklist to help you spot weaknesses and deficiencies in plan operations, investments and investment advice. Many times these checklists are free and can save you a lot of headaches should DOL drop by for a plan audit.
Talk To Your Employees about Your Plan - Face it, ERISA lawsuits are initiated by unhappy participants. Are your employees happy with your 401(k) plan? Is it the benefit it was intended to be? What are your employees’ experiences like when they seek advice and guidance? Is your plan focused on positive outcomes, i.e. successful retirements?
Shop Your Plan - The 401(k) landscape is changing rapidly due to increased regulation, competitive pressure and litigation. The positive side to this is that costs are being driven down and both the availability and quality of investment advice are increasing. It has never been more possible to obtain a better deal, both for you and for your employees.
We have free resources available to help you analyze and benchmark your 401(k) plan and review your fiduciary risk exposure. We can help guide you through the tasks above to ensure that you are protecting both yourself and your employees. Contact us at firstname.lastname@example.org