Budgeting for investments is critical to becoming a successful investor. Without a clear budget that defines how much and how often you are going to contribute to your investment portfolio, you will find it difficult to make continuous gains in your net worth.
In this post we’ll discuss:
- The relationship between budgets and investing
- Automating your investments
- Dollar-cost averaging
Budgeting for Investments: The relationship between budgets and investing
An important aspect of making your investments grow is to continuously contribute more money to your investment portfolio. Where does this money come from?
It is important to pay yourself first. In other words, make sure there is a line item in your budget that specifically sets money aside to invest. If you don’t specifically set this money aside, you’ll get to the end of the month with no spare money. This will leave you unable to invest for that month. If this cycle repeats for many months or years at a time, you could look back and see that you never took advantage of the time value of your money. Don’t worry if you haven’t started this process yet. There is no better day to start than right now.
The key thing to remember is that most mainstream investments require money. If you want to purchase a stock you have to pay a certain amount of money to buy that stock from someone else. The same applies if you want to purchase a bond. Therefore, you need to budget the money to purchase these investments.
Automating your investments
What do I mean when I say automate your investments?
If you are working at an employer that offers a 401k, this could mean signing up for automatic withdrawals from your paycheck into the 401k. The same also applies to a 403b. If you don’t have a 401k or 403b, this would mean automatic transfer of money from your checking account into a savings or brokerage account designated for investments, such as an IRA. If you are a passive or active investor you will want to see if you can have your brokerage automatically use new money to purchase additional investments. DIY Investors will want to manually manage this money, but it is still important to automatically put the money into your investing accounts.
It is important to automate your investments because each step in a process that takes time or effort makes it less likely to happen. If you want to make your investing process successful, then you need to eliminate as many steps of this process as possible. Therefore, automate as much as you are comfortable automating.
I will dedicate an entire post to this topic at a later point, but this process allows you to take advantage of dollar-cost averaging. By investing slowly and consistently over time, you are able to purchase investments at both the lows and the highs. Since it is impossible to predict the market, this ensures that even if you begin investing at the highs of a market, you will eventually be buying at the lows which will “average” your purchase price to be a good one in the long term.
This effect is compounded by the fact that if you invest the same amount of money each month, you will be buying more shares at low prices and less shares at high prices.
Example: If you invest $500/month and the stock you want to buy costs $10/share. Then you will buy 50 shares that month. If the next month, the stock increased in value to $20/share, then you would buy 25 shares that month for a total of 75 shares. Your first thought might be that your average cost was $15/share, but this isn’t true. In fact, it’s lower than $15 per share. Your average cost is actually $1000 divided by 75 shares which equals $13.33 per share.
This is the great effect of dollar-cost averaging. You benefit more from buying at low prices than you are hurt by buying at high prices.
Remember that budgeting for investments is a key factor in successful investing. Only by setting this money aside and automating the task of investing will you be able to reliably invest each and every month. This will allow you to reap the benefits of dollar-cost averaging which will improve your returns over time.
Do you set a specific budget line item for your investments? How do you handle your budget? Was there something that I missed which could help other readers? Leave a comment below and join the conversation.
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