While we’re on an investing kick this week I thought I should bring up one of the more fundamental ideas of investing, and that is dollar cost averaging. New investers tend to look at performance charts and dream big about buying low and selling high. But it’s impossible to “time the market”. A better strategy is to invest consistently over a long period of time.

Investing the same amount every month, over time, means you will sometimes buy shares when the share price is up, and other times buy shares when the share price is down. But your average cost is what’s important.

This is dollar cost averaging.

Here’s an example of how it works: If I invest in a mutual fund that currently costs $8 per share, and I invest $100 this month, that’s about 12.5 shares. If I invest the same $100 next month, when the share price has gone up to $10, that’s 10 shares. So now I’ve spent a total of $200 on 22.5 shares, which means my average cost per share is $8.89. So at the current $10 price per share, my two-month portfolio of 22.5 shares (which only cost me $200) would be worth $225.

Use this method over 20 or 30 years, and you’ll save yourself huge headaches over trying to time the market, putting all your money into a stock just before it falls, and in the end, coming up short.

Remember that your investing should be for the long-term.

In the short-term, prices might go down. You don’t want to cash out your shares when prices are down. That’s how you lose money. Any money you will need within the next two or three years, should be in CDs or savings accounts, or other guaranteed, but low interest-earning vehicles.

Over time, however, prices have always gone up. Over the last 25 years, the stock market has had an average annual return of +11%. Even over the last nine months, recovering from the largest hit the market’s ever taken, we’ve already recovered more than 50% of the losses. I have no doubt that over the next few years we will see a full recovery. And the only people who will actually lose anything, are those who cash out early, before we recover fully.

There is no best time to begin investing and saving for your future. The best time is right now, or as soon as you’re out of debt. And the best way is slow and steady and consistent. It’s boring, but it works.

Today I wanted to discuss the two most popular retirement accounts, their advantages and disadvantages, and why you should care.

We’re going to look at the 401(k) retirement account, which is typically available to those working for bigger businesses and corporations, and the Roth IRA retirement account, which is typically used by self-employed or freelancing workers. The rules for these accounts are set by the US Government and may change after this article is published. Always check that you know the current rules before investing.

401(k)s are what we hear discussed the most. 401(k)s are typically offered by the company you work for. You can have a portion of your income contributed, before taxes, to your 401(k) retirement account. It’s important that I mention the ‘before taxes’ part, because that’s one of the biggest differences between a 401(k) and a Roth IRA. Because you contribute money to your 401(k) before it is taxed, you lower your taxable income for the year in which you contribute, which also possibly lowers your income tax bracket, saving you money at tax time.

Your employer may even match a portion or all of your contributions to your 401(k). If your employer will match your contributions, I highly advise you contribute up to the employer’s match, as this is free money every month. Your employer is not obligated to match contributions though, so not all of you will have this opportunity.

When you retire and begin taking distributions from your 401(k), those distributions are taxed at your future income tax bracket because you contributed the money pre-tax while you were working. So all of the wealth you’ve accumulated in your 401(k) will be taxed as you withdraw it after retirement. As you will soon see, this is another big difference between 401(k)s and Roth IRAs.

So what’s a Roth IRA?

Roth IRAs are retirement accounts you set up individually, outside of your employer. Roth IRAs are one of the few (but not only) retirement account options for self-employed workers. The money you contribute to a Roth IRA is after tax money. You’ve already paid income tax on this money. Because of this, when you begin taking distributions from your Roth IRA upon retirement, your distributions are tax free. You won’t pay a penny of tax on distributions of your original contributions nor the decades of growth and interest and dividends within your Roth IRA account. This is what makes Roth IRAs so attractive.

One drawback to the Roth IRA is the low annual contribution limit. You are only allowed to currently contribute $5,000 per year to your Roth IRA. And if you miss a year, or don’t contribute the full $5,000, you’re out of luck – you can’t make that time up. This is why it is so important to open and start contributing to a Roth IRA when you’re as young as possible. Even if you only put in $20/month, it’s better than nothing, and it’s time that you won’t be able to get back.

The later you start, the harder you have to work and the more you’ll have to save. By starting early, even with smaller amounts, your money will have more time to grow, compound interest will display its positive effect on your cash, and your nest egg will grow beyond belief. If you wait until you’re 40 to start, you’ll have to work five times as hard, for half the reward.

No one has retirement on the brain at 18 or 19 years old, but if I could change just one thing about my financial past, it would be starting a Roth IRA right out of high school instead of waiting until I was 25. I cannot stress this enough, knowing that 41% of my readers are under 18, and another 17% are under 24.

If you’re currently working for a company that offers a 401(k) plan, ask them about employer matches and start contributing. Then, whether your employer offers a 401(k) or you work for yourself, everyone is able to open a Roth IRA account. So do that. It doesn’t cost anything to get started, and you can contribute as much or as little as you can afford each month (up to the $5,000 annual limit).

Roth IRAs can be set up online at E*Trade (which is where mine is), T. Rowe Price and many other online brokerages. Don’t worry about what to invest in within your Roth IRA yet, just get it started, and start contributing. We’ll have plenty of time to talk about investment options later, or you can reread yesterday’s article for some brief overviews of the investment options available to you.

No one wants to retire to a restrictive budget and a menu of cat food. And you won’t have to, if you just start early, and contribute often.

Yesterday I had a reader ask what his investment options were. After asking him to reconsider his current debt and income, he came to realize he wasn’t ready to invest at this time. But that doesn’t mean you are in the same place as he is, financially. So, today I decided to run down some of the investing options available to you.

When you start saving your money, instead of giving it to credit card companies every month, you’ll want that money not only to be safe, but to grow. The growth of your money is almost directly related to the risk you’re willing to take with it. Someone willing to take almost zero risk with their money will be lucky if they can keep up with inflation. While someone willing to take a slightly more educated risk, may reap larger rewards.

Before we look at our investment options I should point out that everything here is drawn from my own experiences and none of it may be right for you and your money situation. This is not me recommending you do anything specific with your money; this is simply me making you aware of some of your investing options.

Online Savings Account. Online savings accounts pay much higher interest rates than local banks typically pay. With the fed’s interest rate where it is, no one is paying much interest, but here is a list of some of the current best paying online savings accounts. According to that list, SmartyPig is currently paying 2% interest. Compare that to my local credit union, which is paying .03% (three-tenths of one percent) and you’ll clearly see the advantage. However, average annual inflation is 3-4%, so earning 2% interest is not a good long-term investing strategy, as your money will lose buying power every year. Online savings accounts should be used for your emergency fund and short-term savings only. Online savings accounts are protected by the FDIC, so you are guaranteed not to lose money in your account should the bank go out of business. Risk factor: low. Reward factor: low.

CDs and Savings Bonds. CDs and Government Savings Bonds pay a little bit better rates than online savings accounts, usually. The US Government even sells bonds that adjust at the same rate as inflation each year, to protect your money’s buying power over the life of the bond. CDs usually pay slightly better interest rates than savings accounts because you are agreeing to lock in your money for a given length of time. The longer you lock it in for, the better the rate. A ten-year CD will have a better interest rate than a three-year CD. Just make sure this is money you are not likely to need until the CD matures, or you will pay early redemption fees. Laddered one-year or six-month CDs can be used for your emergency fund. Laddering your CDs means you buy one per month over a one-year time frame. Then you have one bond maturing each and every month, in case you have an emergency and need to cash it. No emergency? Then roll it over into another one-year CD. CDs and Bonds may break-even with inflation each year, but they won’t make you rich. CDs are protected by the FDIC from losses. For the best CD rates, check out bankrate.com Risk factor: low. Reward factor: low.

Mutual Funds. I personally keep the majority of my long-term savings in mutual funds. Specifically, mutual funds that invest in real-estate and corporate bonds. You can look at my investment portfolio to see just how heavily I’m invested in mutual funds. The mutual fund I currently like is the TCW TOTAL RETURN BOND. TCW has an average ten-year annual return of +7.28%. Mutual funds invest in numerous stocks and bonds, spreading risk and diversifying for me automatically. Because of their diversification, mutual funds are typically less risky than owning individual stocks. However, depending on which stocks the mutual fund invests in, your money may still be exposed to numerous risks. The best way to evaluate and compare mutual funds is to look at their ten-year average annual returns. This is long-term investing/saving. You should also consider the expense ratio of your mutual fund, and any other fees that may be associated with it. In the short term, prices raise and prices fall, but in the long-term the market has averaged an annual return of about 10%. Risk factor; medium to high. Reward factor: medium to high.

Stocks. I don’t personally invest in individual stocks. All of my investments are in mutual funds, or target date retirement funds. However, you may wish to own individual stocks in a specific company. If you get in early, or while the stock is low, and then the company does well, you stand to make a lot of money. If you buy when the stock is high, thinking it has no where to go but up, you could lose quite a bit if the company does not continue to grow. It’s a bad idea to buy stock in a company simply because you like what the company does or makes. Your investments should not be emotionally motivated. You should use your head to invest, not your heart. Take a look at the company’s past track record. Take a look at their plans for the future. Can you reasonably deduce that this company will grow? If so, you should feel comfortable investing. If you don’t know, or haven’t looked into it, do not buy their stock. You have no guarantee in the stock market. You could make millions; you could lose everything and have no recourse. I highly recommend you stick to mutual funds and target date retirement funds. Risk factor: high. Reward factor: medium to high.

Online savings accounts can be applied for and opened on your home computer. CDs and Savings Bonds can be purchased from banks or online from Treasury Direct. Mutual Funds will need to be purchased from a brokerage firm. I use E*Trade, but you might also consider TD Ameritrade, T. Rowe Price or Charles Schwab, all of which can be applied for and opened online. Stocks also require a brokerage account.

All of the above are available for both retirement or non-retirement investing/savings accounts. Tomorrow we’ll discuss the differences between the two, the idea of dollar-cost averaging and why starting to save for your retirement now, rather than later, is so important.

The following email was sent in by Freelance Finances reader Zack. I’ve edited out some of the personal details and shortened other sections for reprinting purposes:

Hello, my name is Zack. I’m 18. I recently left college so I’m currently $5,500 in debt from student loans, and now in order to keep up I have to buy a car so that I can get a job to pay off that debt, along with the $10,000 or so that I’ll be in debt for a loan on the car.

I know compared to others’ debt $15,500 really isn’t horrific, but I’ve never had a job before, and no real source of income. Also, my entire savings is gone thanks to college expenses. So now I’m stuck, I need to pay roughly $400 a month for rent, $200 for food, $65 for my school loans, and $300 or so for my auto loan (which I have yet to take out), also another $100 for insurance and finally a last $60 for gas. I can’t pay $1,125 every month!

If I took a part time minimum wage job I’d only be making $870 a month, and that’s before taxes, leaving me in the hole each and every month. I don’t want to live like that, and especially not this young. My parents will help with rent and food, possibly even insurance for a little while. I also have 6 months before my student loan payments start up. So I suppose my question to you is: what do I do?

I have web coding and graphic design skills, so freelancing might be a way to start up some income and build a buffer. I have only $65 to my name at the moment, but once I get some more what I really want to do is invest it in something, and try to start making a return with it.

So I suppose aside from “what do I do?” I’d also like to know how I can smartly spend and save my money. I’ve looked into CD’s, Bond’s, and Money Market accounts, but unless you have $10,000 to begin with the interest on them seems nearly negligible. Perhaps stocks could provide the turn around I’m looking for but then I have to pay broker costs and trade fees and the stocks themselves aren’t very cheap. Is there any way I can start investing without having much more than $100 to begin with?

Sincerely Zack

Hi Zack,

You can’t consider investments at this point. But more on that in a minute.

First things first, you said that you haven’t purchased your new car yet, and that’s good. Don’t! There is no way you can afford a $10,000 car right now. Even with your parent’s help. You don’t have a job. I would recommend that when you do start working, you buy a cheap used car for $3,000 or less. I know new cars have warranties and all that, but cars lose half their value just driving them off the lot. That’s a $5,000 warranty you’re buying there, and nothing else.

A cheap, reliable used car would significantly cut your monthly expenses.

As for rent, would you be opposed to living with a roommate or in your parent’s basement for a few months? Both could cut rent significantly until you get your head above water. I’ve lived with a roommate for the last few years now while paying off my debt and socking money away. It’s not ideal, but cutting utilities and rent bills in half is wonderful for anyone’s budget.

Also, if you’re really looking to build up your emergency fund, or “buffer” as you called it (great term), have you considered a part-time job in the evenings to supplement your full-time job during the day?

You could treat freelancing as your part-time job. That’s how I started. For the first three years I freelanced, I worked full-time during the day for a local non-profit social services agency. I couldn’t afford to live on either job alone at the time.

As for your investing question, I suggest you wait before you tie up any of your money. You have a lot of things that need to be taken care of before you can invest. Investments should be long-term, they should be money you don’t plan on touching for five-ten years or longer. And you just don’t have that kind of extra money to part with right now.

High-reward investments, like stocks, are also high-risk investments, meaning, in the short-term, your stock’s value could go down. Mutual funds, especially those that invest in Bonds, are a safer bet, and what I invest heavily in, but they are not guaranteed to always grow either.

So here’s the plan I am suggesting for you:

• First, get a job. Work on balancing your monthly budget. You need to have a positive number when you subtract your expenses from your income.
• Second, you’ll want to build your emergency fund, or buffer. $500-$1,000 would be a good start for any emergencies that come up. But eventually, 3-8 months of living expenses would be ideal.
• Then begin attacking your debt with any extra money you can find in your budget. Any bonuses at work or birthday or Christmas money, should all go towards debt. I suggest paying off the car first, as the interest rate on the auto loan will most likely be higher than on the school loans and the amount should be lower, so you can get it paid off and snowball that payment into your student loan payment.

All of that needs to happen before you can consider investing. It won’t happen quickly, but you’re young and eager to start down the right path, so that’s good. When you’ve paid off the debt you have now, send me another email, update me on where you’re at, and we can talk investing at that time.