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Dad’s (Grown) Girl: The Power of DCA

Posted by Keith on April 12, 2007 at 9:46 am  

Keith,

Our daughter will start her teaching career next fall. I am encouraging her to consider living at home for 3-4 years to save most of her salary. That way she might be able to purchase a home. If she were to do this what strategy would you recommend for saving/investing an annual amount of about $25K.

Enjoy the fresh fish dinner. Smooth sailing,

Matt

Dear Matt (from 280 miles NW of Honolulu),

What are you thinking?

Change the locks! Switch phone numbers! Hide! Your daughter is a grown woman and a college graduate. Let her spread her wings! She needs her own place, her own problems and her own plan. She’ll work it out! Hell, you just dropped a ton on a college education. Let her use it!

So she saves less than $25,000 per year toward that house, or whatever. She’s young. She’ll figure it out.

Have I convinced you? No? Well, regardless where your daughter lives, or with whom, here’s what every young person should do

Dollar Cost Averaging

By setting aside some money every pay day (whether or not she lives with you), your daughter will be practicing dollar cost averaging. The beauty of DCA is that as you invest a fixed sum periodically (without fail), or a fixed percentage of your income, that money buys more when markets are down, and less when markets are up.

Thus, a young accumulator is actually better off if markets stay depressed early in their DCA career, as they will accumulate more shares that way.

However, before you daughter invests a dime, she should set aside 3-6 months of living expenses (her real living expenses, as if she were on her own) in a risk-free savings account, so that if an emergency arises she will not have to raid her investments, possibly at a time when it is not advantageous to liquidate holdings.

Maintaining a cash reserve is always the top priority. Otherwise, her investment program is doomed. Something will come up. The car will need a repair. She’ll decide she simply must take that spring break trip to Bimini (Teachers can party too!), or her boyfriend will need bail money. Whatever, something will arise. So encourage her to maintain that cash reserve, and to replenish it immediately if she dips into it.

I personally think that even with, say, a five-year time-line to purchase a first-time home, a young person should stick entirely with equities, not bonds, until just a few months before they are ready to make a home-purchase decision. Then they should switch to cash so they can clearly define the money with which they have to work.

However, someone investing small periodic sums should not purchase individual stocks. The transaction costs would be murder as a percentage of the amount invested, and the investor would not have sufficient diversification.

Mutual funds are OK, but for starters I would stick with broad index exchange traded funds. There are ETFs that track the Dow, the S&P 500, NASDAQ, and many major world indexes. That’s plenty for someone in your daughter’s situation.

These ETFs are less expensive than mutual funds, and provide excellent diversification.

An ETF managers such as Efficient Market Advisors (see ad on our home page), one of our sponsors, can perform a valuable service by developing ETF portfoloios based on your daughter’s individual risk tolerance.

I would suggest that your daughter either talk to a retail representative at, say, Schwab, or contact an ETF manager such as Efficient Market Advisors.

The key – whether she lives with you or not, and whether she purchases a home within a few years or not – is that your daughter embark on a DCA savings and investment plan starting with her first pay check – and that she continue that discipline during her working life.

If your daughter is a public school teacher, she will probably benefit from a 403(b) plan – the state equivalent of a 401(k) plan. This also involves the concept of DCA, but on a tax deferred basis. Generally, she will not be able to access these funds until retirement (there are exceptions), but she should always make the maximum contribution allowed to her plan.

Meanwhile, she should also maintain a non-qualified (outside of a tax deferred retirement plan) DCA program. By doing both – weather she lives with you or on her own – she will accumulate wealth far in excess of the average American.

–Keith


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