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Your Automatic Investment Plan

Over the past couple of weeks, I’ve laid out three steps to help you build a hassle-free money management system:

  1. How to manage your spending without a traditional budget.
  2. How to create a bank account buffer to eliminate the risk of overdrafts.
  3. How to put your bills and savings on autopilot.

What I’ve written is incomplete, however, without one piece of the puzzle: an automatic investment plan.

Arguably, putting your investments on autopilot is the most important thing you can do for your finances.

If you don’t want to automate the rest of your finances—if you prefer to set aside a few hours a month to pay bills, transfer money to savings, and balance your checkbook, that’s fine. Some people will sacrifice time for that kind of control. But you should still consider setting up automated investments.

Investor and financial author Robert G. Allen sums up the biggest reason:

How many millionaires do you know who have become wealthy by investing in savings accounts? I rest my case.

Many of us delay investing (or fail to start at all) because we’re either intimidated by choosing investments or we’re afraid of the risk. An automatic investment plan can help. One of the techniques I outline here requires zero investing knowledge to get started—it’s as easy as opening a bank account. And, when you put your investments on autopilot, you take your emotions out of investing, which can temper your fear—or at least limit fear’s ability to cost you money. Let’s look at how an automatic investment plan does this.

Dollar Cost Averaging

The technique of buying a fixed amount of an investment at regular intervals is known as dollar cost averaging (as opposed to investing a big chunk of money at irregular times).

If you were to buy $1,000 of a mutual fund when it’s per-share price is $100, you would own 10 shares.

If, however, you invest $100 a month for ten months and the fund’s price varies from $80 to $120, you may end up slightly more or less than 10 shares depending on the stocks prices. As the market climbs, the notion is you will end up buying more shares at a lower price than if you invested in a lump sum. Advocates of dollar cost averaging say this reduces risk, but critics disagree. The market goes up in the long run, so you want to get money in as soon as possible.

If you have a lump sum sitting around that you want to invest, then do it. Get it into the market and don’t worry about spreading it around and definitely don’t try to time the market or wait for the right time.

For the rest of us, an automatic investment plan makes sense for two reasons:

  1. It lets you invest on a regular schedule.
  2. It prevents self-sabotage.

INVEST AS YOU’RE PAID

Ask people who are successful at saving and building wealth and you’ll find that many of them have two things in common:

  1. They invest, rather than leaving all of their cash in a bank account.
  2. They pay themselves first.

I’ve recommended paying yourself first as a strategy for building cash savings for emergencies, and you can do the same thing with your investments.

Your employer may make this easy by offering a 401(k) or similar retirement plan to which you can contribute through automatic payroll deductions.

Otherwise, you can start a Roth IRA and begin making regular contributions on paydays in addition to cash you transfer to a savings account.

Are you already saving enough for emergencies and retirement? Then it’s time to open a nonretirement investing account and put money away for “life”. Use this flowchart to help you decide how to allocate your investing dollars:

Use this flowchart to determine where to start your autopilot investments.

PREVENT SELF-SABOTAGE

You can’t rely on willpower to reach your financial goals.

You may be able to hunker down and fight the urge to splurge at the mall or bet on a hot stock tip…for a while. But eventually your emotions will get the best of you. You’ll calm your nerves after a tough week with a spending spree. Or give into fear and postpone an investment during a volatile month in the market.

Carl Richards, author of The Behavior Gap, knows this, and in a recent New York Times blog post offers the same advice I’m giving now: Use automation prevent your emotions from influencing your financial decisions.

HOW TO SET UP AUTOMATIC INVESTMENTS

Nearly every mutual fund company and online stock brokerage makes it easy to set up automatic investing in mutual funds, whether it’s in an IRA or nonretirement account. Most will waive minimum investment requirements when you enroll in an automatic investment plan.

This is how it works:

  1. You set up an automatic transfer from your bank account to your investment account (for example, on pay day).
  2. You specify which mutual fund(s) to invest in and your money is automatically invested at the current price.

The key to keeping automatic investing affordable is to invest directly with a mutual fund company (for example, buy Vanugard funds through Vanguard or Fidelity funds through Fidelity) to avoid paying a trade commission each month. Alternatively, some online brokers (TD Ameritrade*, for one) offer hundreds of no-transaction-fee mutual funds in which you can automatically invest with no extra fees.

WHAT ABOUT INDIVIDUAL STOCKS?

Mutual funds make automated investing easy because you can invest any amount in a mutual fund regardless of the current price. (You can buy fractions of a share.)

In most cases, however, with individual stocks and exchange-traded-funds, you must purchase whole shares. So if you want to automatically invest $100 in ABC stock with a current price of $11, you can only buy nine shares and will have a $1 left over.

One way around this is with ShareBuilder, an alternative broker owned ING Direct. ShareBuilder’s entire model is built around automatic investing plans, and for $4 a month you can invest a fixed amount in individual stocks as well as mutual funds (you can hold fractional shares).

A final alternative to both direct mutual fund investing and ShareBuilder is Betterment, the new radically simple investing account that lets you make autopilot investments in entire stock and bond markets. Investing with Betterment is about as simple as opening a bank account, and I think it’s a perfectly acceptable strategy for hands-off investors.

What about you? Do you have an automatic investment plan? How do you structure it? Where do you invest? Let me know in a comment.

Note: MoneyUnder30 has financial relationships with the following companies mentioned in this post: TDAmeritrade, ShareBuilder, and Betterment. We may earn a referral commission if you visit one of these companies and ultimately open an account. If you choose to support our free content in this way, thanks!

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About David Weliver

David Weliver is the founding editor of Money Under 30. He's a cited authority on personal finance and the unique money issues we face during our first two decades as adults. He lives in Maine with his wife and two children.

Comments

  1. I was looking at the chart… Are you saying if you have access to a 401K (or the like) but your job ins’t matching the funds, just skip it and do a Roth IRA? I’m in that situation… I work for a very large company and I am one of the few employees that are in a unionbecause it was around before we were bought. Union employees can’t get the match. They got about $300 out of me by the time I figured this out so I have stopped putting in money. After I build my emergency fund, should I start looking at a Roth?

    • David Weliver says:

      Right, if your company doesn’t match 401(k) contributions, I think a Roth IRA is a better bet. For most young investors the tax strategy of a Roth is better and you have more control over investments,so you can pick mutual funds with lower expenses.

      • Thanks! Now I am in school and if I get hired to a different position, I will no longer be union so I can get the match. By then I will be making much more money. Should I maintain the roth and 401K?

  2. This road map is great information, but I have a question. I don’t understand the reason to max out a Roth IRA separate from your 401(k) before continuing on to max out the 401(k).

    • 401k matching is like instantly doubling your contribution, nothing beats that. Once the matching is over, all you get is deferred taxes on your contribution. (nice, but not that exciting) With a Roth account the earnings are tax free, which is pretty awesome.

      That’s why he recommends to allocate your money in that order.

      • There are 2 meanings of “max out” for 401K. In the first sense, you max out whatever your employeer will match (e.g. your employer will match your contributions up to 5% of your salary). The second sense is the max amount you can legally contribute to your 401k as defined by the IRS. So, the flow of money should be: contribute to your 401k up to your employer’s match, then contribute as much as is allowed to a Roth IRA, and then contribute up the max amount for 401K. All of these contributions will have tax incentives, which is why you max them out before getting a brokerage account (which requires you to pay tax on your gains).

  3. I max my Roth, then go directly to a non-retirement account since my employer doesn’t match 401k contributions. I pay on my gains, but my industry is volatile so it’s nice to have access if things ever hit bottom without penalty. That’ll also be helpful down the line since I don’t plan on waiting until 65 1/2 to retire. I understand it’s not for everyone, but the movers and shakers might consider skipping the 401k if employers don’t match to save some penalties in the first years after the working world.

  4. Nicole C. says:

    “If you don’t want to automate the rest of your finances—if you prefer to set aside a few hours a month to pay bills, transfer money to savings, and balance your checkbook, that’s fine.” It speaks to me. I do that not because I like THE CONTROL. It is because I get paid every Wednesday, instead of fixed dates like: 15th & 30th.
    And, I do have automated investments: Money is deducted from paycheck to 401(k) automatic in each pay period, and I am contributing three times a month to my ROTH IRAs with T. Rowe Price.

    David, Would you tell me which step are you at? [refer to six (and a half) steps to financial stability].
    I am between step 4 and 5. I will max out ROTH IRA for year 2011 by April, and I save to pay my next car in cash.

  5. David Weliver says:

    To answer a couple of the questions on the flowchart. Obviously, this is a simplification and many of you may have good reasons for deviating from this path (for example: wanting to invest more for the short term than for retirement because of upcoming expenses or volatile income). This assumes that the investor wants to take advantage of all available tax-advantaged retirement accounts before investing in a taxable account.

    There’s no reason you can’t contribute to both a Roth and your 401(k). If you can afford to max out both simultaneously, more power to you!

    What I hope the chart can do is help people figure out where to start. If you have limited dollars to invest, start with a matched 401(k). If you have more to invest, move onto a Roth IRA. Still more? Add more the 401(k) or a combination of the 401(k) and a taxable account that you can use for expenses before you retire.

  6. This was a really good article. I just went through setting my retirement plan up with an advisor and have money automatically going away every month. It does feel a little weird but I know I need to stick through it.

  7. My automatic investment plan is through my 457 (deferred compensation) plan through work. My primary retirement investment account is in a Roth IRA though and I like using Vanguard index funds.

    I’m beginning to question the value of dollar-cost averaging and started an experiment to see how regular interval investing differs from all at once investing at the beginning of the year.

    I do, however, believe that it’s a great method for most people who don’t like to or don’t have a lot of time to dedicate to their investments. Automated investing is a great tool to make sure your retirement is on track and you don’t divert those funds into non-essential purchases.

  8. Sharon Ickes says:

    I am surprised by the number of articles I read that never mention dividend reinvestment plans available through major companies with very long history of increased dividends. I got rid of anxiety and constant tracking by placing a large amount of my savings in DRIPS. More people should be aware of them. Thanks for your informative article.

  9. Where would a Roth 401k fit into your chart? My employer offers both so I put my contribution in my Roth 401k and then they give me my match in a traditional 401k.

  10. Hi David! I just started a blog about a month ago about money management so I’ve been reading through a lot of similar blogs. I really like the content you’re sharing on here and it would be great if we could get in touch to share information, especially on building blogs and generating traffic. I actually referenced your site in my most recent post! (I hope you don’t mind the free advertising :)) You can check it out, and the rest of my content, at http://www.financeyourfutureu.com. If you’re interested in speaking further about finance/money mgmt blogging, let me know!
    -Kristy

  11. I second Jessica’s question on the Roth 401(k). What if your annual income exceeds the standard Roth IRA requirement? So you look to make your 401(k) or pursue a Roth 401(k) contribution first?

  12. David Cole says:

    How about if you did max the Roth where would one look at another type of investment that I could have easy access to. I’m thinking this would be just a mutual fund. Also I had a 401k that I did not get a match on, now I have a Roth IRA. Do I roll the 401k into a IRA or leave it. Also can you have two Roths when you are married and my wife currenlty just goes to school.

  13. Hello!

    Great Information. I am just starting out and my employer matches up to 5%. I want to start a 401K plan but I do not what were to invest my contributions or if I should invest at all. I have over $50K in student loans at over $10k in credit card debt. I don’t have any savings since I am just starting out Any advice?