Let’s say you just inherited $10,000 on January 1, 2011 from your Great Uncle Herbert. Uncle Herbert may have been quick to lecture and always smelled like icy hot, but he was a financial whiz who knew how to save and invest. In his will, smelly Uncle Herb put one condition on your inheritance. You had to invest your money for at least 20 years. He wasn’t completely controlling, so he let you decide between two investment strategies: Lump Sum or Dollar Cost Averaging.

Choice #1: Lump Sum

Lump Sum investing is exactly what it sounds like. If you choose this strategy, you must invest all $10,000 on January 1, 2011.

Choice #2: Dollar Cost Average

Dollar Cost Averaging is putting a set amount of money into the market at a predetermined interval for a certain time horizon. The premise behind this strategy is that your money buys more shares when the price is low and less shares when the price is high. If you choose this strategy, you must invest the same amount on the first of each month for one whole year.

n 20 years, which investment strategy do you think comes out ahead?

Well, there is no way to know for sure unless you’re Michael J. Fox, and back from the future. But using historical data from 1950 to the present, odds are that the Lump Sum strategy outperforms the Dollar Cost Averaging strategy. (Of course, past performance isn’t an indicator future performance.)

If you would like to run the numbers, you can do so quite easily using the calculator and data created at MoneyChimp.

The problem is, most of us don’t have large sums of money sitting around waiting to be invested. And by piling up cash for an extended periods of time, and finally investing the pile at once severely limits the power of compounding. Since I sit with the majority, I’ll continue to invest my predetermined percentage into the market each month as I’m paid. But you know, even if I were to receive a large windfall from Uncle Herbert, I’m not sure my gut could handle the stress of throwing it all in at once, regardless of what the statistics say.

What about you? If you were given the above scenario in real life, knowing what you know now, which strategy would you choose?

As I picked up the latest SmartMoney magazine up off my desk, I realized that I am usually drawn to the retirement articles first. I’m always eager to check out the latest information and can’t digest enough of it to satisfy my questions, such as:

• Am I saving enough for retirement?
• What if I really want to retire early?
• Am I investing my money in the right places?

But today, this realization hit me in an almost eerie kind of way.  Why am I so obsessed with retirement?   Do I hate my job so much that I can’t wait for the day I am able to walk out the door for good?

I don’t know.  That’s a lot to think about.  I’m only 27.  If the traditional retirement age is 65 (and recent signs indicate that this age will be increasing) that’s a long time to be miserable.  But, I don’t hate my job.  I don’t love my job either, but I do love certain aspects about my job.  There’s the people, and the steady paycheck.  I feel good about the industry in which I work.  I feel like I make a difference.

However, I still find myself wanting for more.  I’m guessing my wife (a psychology professor) would tell me that it’s a natural part of the human condition (or something like that…)  More of what, I’m not exactly sure, but there are a few things that come to mind:

1. Satisfaction
2. Security
3. Money
4. Freedom From the 8-5 Routine
5. Opportunity
6. Stimulation
7. Less Stress

It’s interesting that retirement doesn’t necessarily provide me with any of these things, other than #3.  Am I spending too much time obsessing over retirement?  Even after contemplating the items above, I don’t think so.  Regardless of my feelings about my full time job, the need to take care of me and my family will always exist, including the day I am no longer able to work, even if I want to.

What do you think?  Can you relate, or am I the odd ball out in left field?

Times must be good, you know why? It’s been awhile since I noticed a story touting hot stocks like this one on the front page of MSN.

I don’t necessarily suggest you start paying attention to anybody predicting which stocks to follow, but you should take a moment to think back over the past couple of years. I don’t remember how low the DOW actually fell, but the number 6 hundred something pops into my head.

People had given up on the stock market for good. People panicked, and people sold low. Were you one of them? These same people are probably thinking about jumping back into the market again now that the good times appear to be peeking around corner (at least in comparison to the last couple of years.)

I’m not suggesting that you dip your toes back into the water or get out of the water all together. In my opinion, there is actually a more sane way of investing, and avoiding the volatility that surrounds the everyday market, called dollar cost averaging. For what its worth, this is the strategy we use and I sleep like a baby (albeit an old ugly baby.)

Regardless of what is going on today, if you couldn’t take the heat when the ship felt like it was sinking, its possible that you need to reevaluate how your risk tolerance is intertwined within your investment mix. If you are losing sleep at night over your investments, you probably shouldn’t have your money in said investments. Is the risk/reward tied to said investments really worth your sanity and mental health? I think not.

Dollar Cost Averaging is a simple and common investment strategy used to minimize the average cost per share of an investment over time.  When done correctly, the investor determines the amount to be invested, how frequently they will invest their predetermined amount, and how long they plan to make their periodic investments.

Why You Should Consider Dollar Cost Averaging

In reality, most working schlubs like myself don’t have piles of money just sitting there waiting to be invested.  (But if you do, you might consider an alternative strategy that is referred to as lump sum investing.)  However, I do receive a paycheck on a biweekly basis and choose to send the same amount to the same investments, each and every time I am paid.

By purchasing the same dollar amount of shares over a period of time, my money buys more shares when the investment price is low, and fewer shares when the investment price is high.  Theoretically, this strategy reduces long term risk and eliminates the possibility of throwing all of my money into an investment at its peak.

This strategy is not without its critics, but for me, it is the most practical and sane way of investing for your long term goals.

I always hated math.  I know it isn’t evident from my writing style or the plethora of monosyllabic words used throughout this blog, but I always preferred English…well band, athletics, and lunch really.  However, I do love simple formulas that reveal useful things that are applicable to the real world. Hence, The Rule of 72:

The rule of 72 refers to an easy mathematical formula that can be used to quickly determine how long it will take your money to double via compound interest.

72 / interest rate = years it will take for initial investment to double

72/8 percent = 9 years

Remember Algebra class?  This formula can also be used backwards to determine what percentage rate one needs to achieve in order to double their investments in a predetermined number of years.

72 / years = percent needed to double money

72/9 years = 8 percent

Time is Money

When looking at the chart, you’ll notice there is a huge difference between a 1% return and a 12% return.  The sooner you start investing, the more time compound interest can work its magic and double your money.

Have you ever been asked if you would rather receive 1 million dollars now or a penny on the first day of the month, with the caveat that your penny and the total amount at the end of each day would double for an entire month?  Most people choose the 1 million dollars, but the penny that turns into 2 cents the second day, 4 cents the third day, and 8 cents the fourth day eventually totals over 5 million dollars by the end of the month.  That is how important your interest rate is to your final balance over the years.

Oh, and if anyone knows where I can find consistent 10% – 15% returns, be sure and let me know.

Would you like to drive free cars for the rest of your life?  And what if I told you that you could become a millionaire while doing so?  According to a plan entitled, "Drive Free, Retire Rich" on Dave Ramsey's website, you can do just that.  Interested?  If you are like me, then I bet you are.  Who wouldn't want to drive a different car every 5 to 6 years without ever making another payment?

The first time I viewed this video I was so excited and inspired that I made my wife watch the video with me.  I sent the link to my family, and I even posted the link on my personal finance class discussion board for my classmates to view.  The video assumes that by making a car payment to yourself every month for 6 years and investing it in a mutual fund earning 12% each year, you will be able to purchase new cars off the interest earned in the fund.  It assumes that after the first 6 years of payments, you will never again have to touch your principal investment, or have to make another payment and still purchase an $18,000 vehicle every 6 years.

I first viewed this video during the summer of 2008, almost one year ago to the date.  Things sure have changed since then.

Although it appears we have rebounded from the market's bottom, the majority of investors watched their portfolios lose 50% of their values during the past 6 months to a year.  What if you had begun paying yourself that car payment, let's say $500, every month beginning in January, 2003?  You would have invested $36,000 by January, 2009.  Now if your investment had actually grown 12% for 5 1/2 years, then your total investment would have grown to $46,423!  Awesome.  But we all know what happened during the fall of 2008.  For the sake of simplicity, let's assume like many, your portfolio was roughly sliced in half by January 2009, the time when you are supposedly able to make your last car payment and drive free cars for the rest of your life.  Your balance would have fallen somewhere in the $20,000 to $25,000 range.  Now this would enable you to purchase your next car, and you will never have paid a dime in interest to the bank.  However, you would have been sorely dissapointed once you realized that you would have to continue to make car payments to purchase your next vehicle, even if the payment is to yourself. (Assuming your purchase price is near $20,000 as illustrated in the video.)

I do think this is a great idea, and one that my wife and I are working to implement.  But you must keep in mind that if something sounds too good to be true, it probably is.  This video totally ignores the risk involved when investing in stock mutual funds.  Many financial experts recommend keeping any money you will need in 5 years out of the market, because of the risk involved.  This is something to keep in mind when considering if this plan is right for you and your family.

What are your thoughts on this idea?  I would love to hear what others think regarding this one!  You can view the video here.

I'm not an investing pro, but I'm not a newbie either.  I've sat through several classes and learned the basics, including those on bonds.  However, I've never spent much time outside the classroom researching this investment class. 

The biggest reason has to do with my investing style.  I'm 25 years old and the only investments I own are for one specific goal – retirement.  In other words, I don't need this money anytime soon.  If my retirement investments completely dry up tomorrow, I wouldn't even notice.  Ok, so I may be exaggerating, but only slightly.  My point is this. In general, bonds are more conservative investments than equities.  Bond returns are more stable in the short term, but over the long term, bonds will under perform equities.  Even if the difference is only a few percentage points, the size of my nest egg in 40 years could vary greatly, thanks to compound interest.  Therefore, I have basically chosen to ignore this asset or investment class…until now.

I'm perfectly comfortable with 100% of my retirement investments residing in stocks.  But soon, I will be investing for goals other than retirement.  Most, if not all of these goals I hope to reach well before retirement.  This means I will be looking for more conservative investments, investments that will still earn more than my local bank's savings account, but without an extraordinary amount of short term risk.

This is why I will be covering everything from the types of bonds available, to when and why you might consider investing in certain types of bonds.  If you have any questions, I'll be glad to try and find the answer!

How much is enough?  That can be an overwhelming question for someone in their 50′s or 60′s and downright unfathomable for someone in their mid-twenties.  There are just too many “what-if’s” in our future.  A few obvious “what-if’s” include:

• When do I want to retire?
• When can I retire?
• How long will I live?
• How will my health affect how much I need?
• What about social security?
• What are my retirement goals? (travel, vacations, country club memberships etc.)

And this is only the tip of the iceberg.

Even though you will have a hard time answering these questions accurately, it does not mean that you can’t develop an adequate long-term retirement plan.  Here are two different ways the financial planning community might go about helping you estimate your expenses in retirement:

1. Replacement Ratio Method – method used to estimate after-tax retirement income needs in current dollars by multiplying current expenses by a factor of 70 to 80 percent.

For example: if our current estimated expenses are $55,000 per year and I assume that my expenses after retirement will be 80 percent of current expenses, the replacement ratio method will suggest that my retirement needs in today’s dollars are $55,000 X .8 = $44,000.00.

The problem with the Replacement Ratio Method is that I really can’t be sure that my yearly expenses in retirement will be less than they are today.  In addition, I haven’t found any hard statistics that actually prove retirees’ expenses are 70 to 80 percent less in retirement.  Nonetheless, it is a common way to get one started.

2.  Adjusted Expense Method – method used to estimate after-tax retirement income needs in current dollars by adjusting current expenses for changes expected in retirement.

This method is obviously more cumbersome to calculate.  But it is a more accurate measure than the replacement ratio method detailed above.  For example, you may be paying a mortgage now, but you may be expecting to be mortgage free by retirement.  You should adjust the mortgage amount expense accordingly.

So now what?  Either of these methods is a great way to estimate your future retirement expenses.  But of course, you may be thinking I forgot something, right?  After all, my blog is called “The Broke M.B.A.” and the thought has crossed your mind once or twice that I’m broke for a reason…. Ok, I’m assuming being broke has more to do with me not quite being out of school yet instead of a lack of intellect.  Nonetheless, we have yet to talk about one final concept, regardless of the method used: adjusting for inflation.

That’s right, each method above calculated our needs in today’s dollars. We’ll have to adjust this for inflation.  The time value of money concept illustrates why $44,000 today is not the same as $44,000 25 years from now.  To adjust your estimated retirement income needs for inflation, use this formula:

This formula indicates that when I retire in 35 years, $44,000 will be the equivalent of $173,627.91.  If this sounds like an incredible number, it’s because it is.  But don’t forget that your investments will also be taking advantage of compound interest and should hopefully out pace the 4% estimated inflation.

There is one final thing to consider.  Don’t forget to factor in the income taxes you will have to pay when you begin withrdrawing funds from your retirement accounts.  Who knows what the tax code will look like in 35 years, but it would be wise to keep this in mind. (In an effort to minimize your future retirment income taxes, you should consider taking advantage of vehicles that let your money grow tax-free such as the Roth IRA.)

The Dow plunged 640 points today, the fourth largest point drop in history, and I couldn’t be happier.  That’s right, I said happier! Of course, I am in a unique position to benefit long-term from the recent market’s turmoil. Let me explain:

I am 26 years old and have little assets. In other words, I have very little to lose.  But the opportunity for long-term gains are astounding.  Let’s use the S&P 500 as the benchmark for this example.  If I began investing in July, 1932 (near the markets bottom during the great depression) and continued investing each month for the next 40 years, I would have earned a rough average of 13% on my investments.

However, If I had waited for the market to recover (5 years later) before beginning my 40 year investing habit, I would have only earned a fraction over 9%.

Even a 9% average return is amazing, but the difference 4% compounded over time makes is unbelievable. (Unless you are familiar with the magic like effects of compound interest.)  To help illustrate my point, let’s use the same example from above. If I had waited the 5 years for the markets to recover and began investing $800 each month for 40 years, my investments would have grown to roughly $3,775,000. Not bad.

But if I had been able to ignore the masses and began investing near the market’s bottom, $800 dollars a month for 40 years would have grown into almost $13,000,000! That 4% adds up to just over a $9,000,000 difference over the span of my investment period!

So you may or may not wonder how this relates to my thoughts on today’s economy.  No, I don’t think that we are in another Great Depression.  The statistics say we are not.  And yes, I know that we can’t necessarily use history as an indicator for the stock market’s future.  But, I do believe in America’s economic/capitalistic ideals and that this bleak period will pass.  I don’t know when, no one does. But I do know that 40 years from now, I’ll be glad that I took advantage of the opportunities available.

“Building a Solid Financial Foundation – Before you Invest!”

There is no shortage of advice encouraging you to begin investing at a young age, or at least as soon as possible.  This argument is a valid one.  The earlier you begin investing, the more time your money is subjected to the positive effects of compound interest, a phenomenon that Albert Einstein supposedly called the “eighth wonder of the world.”  I’ll save the benefits of compound interest for future posts, but please keep in mind that regardless of how magical compound interest might seem, it is best to have armed yourself with a solid financial foundation before ever dropping a dime into an investment.

My steps to a solid financial foundation:

1. Set short/long-term goals and develop a monthly budget
2. Buy adequate insurance
3. Stash 3-6 months of expenses in a separate savings account to be used only in emergencies
4. Eliminate high interest debt
5. Eliminate low interest debt if able to do so in a relatively short amount of time*

* I consider this step optional depending on your risk tolerance and investing style.  This step sounds counter-intuitive when looking at the mathematics. For example, I could probably beat the 4% interest rate on my outstanding student loans by placing my excess funds into the stock market, assuming a conservative 8% return.  Also, many investors use debt as a tool to increase their wealth. However, there is validity in the psychological benefits associated with being “debt-free,” including a good night’s sleep!

The only exception I have made to financial guideline #1 has been saving for retirement through my company’s 401(k) plan.  They currently match 4% of my contribution and I have taken advantage of this “free money.”  There are too few guarantees when it comes to investing and the company match is a guarantee that you should almost always take.