BBC has been running a series of articles on their website about numbers, in particular how numbers are used and abused so we are made to believe they are telling us something they are not. The articles are good if you want to enhance your financial literacy. Here are some sample quotes from the articles:

• On averages: “What’s the average number of feet? No, not two. The answer is slightly less. Think about it.”
• On percentages: “A 100% increase from one in a million becomes two in a million. So what?”
• On causation: “As more economists are recruited to the Treasury, inflation rises (economists cause inflation?)”

Enjoy!

• Lesson One: Our survey says
• Lesson Two: Myth of counting
• Lesson Three: Percentages
• Lesson Four: Averages
• Lesson Five: Causation (The website shows it as being lesson four, a bit embarrasing to get it wrong considering the articles are about numbers)

DRIP stands for “Dividend Re-Investment Program”. Some listed companies have DRIP’s where dividends are automatically re-invested in more shares from that particular company and usually with no associated trading fees.

I have for example over a period of two years turned 100 General Electric shares into 105 shares by having the dividends (minus taxes) automatically re-invested in additional General Electric shares. Those 5 shares now obviously also contribute to the dividends I receive and re-invest. I am using the principle of compound returns to get ever-increasing dividends from General Electric whether they increase their dividends or not. So it is a great way of slowly but surely growing your portfolio if you can’t or don’t make regular cash contributions to your portfolio.Also, as pointed out in my earlier post about dividend investing in general, in a diversified portfolio capital gains alone usually do not make you rich, but re-invested dividends do.

I don’t know about other brokers, but E*Trade, the broker I use for my US shares, offers the ability to enrol any of my dividend-paying shares in a DRIP without me having to pay any trading fees when the dividends are re-invested. This means that my portfolio frequently contains fractions of a share as the dividends never buy whole amounts of shares. That is not a problem; I get dividends on the fractional shares as well.

When I originally planned this post, I was going to mention that regularly re-investing your dividends constitutes a bit of dollar-cost averaging (at the time I thought dollar-cost averaging was a good thing). Since then I have become more knowledgeable and I would claim that re-investing dividends constitutes a regular contribution.

So here is why I like DRIP’s:

• I get my dividends re-invested right away rather than having to wait until I have received enough dividends to make it worthwhile to make a “normal” trade.
• I don’t pay any trading fees
• I use the principle of compound returns directly on the shares that paid out dividends.

I was going to write about Dollar-Cost Averaging (DCA) as an investment method in preparation to a post about DRIPs (Dividend Re-Investment Program). But first I was going to find some good sources for information about it.As it is impossible to predict how the market is going to perform, DCA is supposed to be a method that lowers the average cost of the shares you buy by regularly buying shares whatever the price of the shares as opposed to buying shares for a lump sum.

With DCA, you regularly invest for a fixed amount of money. If the price of a share goes up, your fixed amount buys fewer shares; if the price goes down your fixed amount buys more shares. If you have a lump sum to invest, DCA says it is better to invest it by buying shares with it at regular intervals for a fixed amount of money rather than investing it in one go.

When my company takes a percentage of my pay and invests in a pension I am dollar-cost-averaging, but it can’t be any other way. The same is true when I take part in the company Employee Stock Purchase Plan (ESPP).

My short research (using Google) showed that a fair amount of academic research has shown DCA to, at best, to fare no better than lump sum investing, and at worst to be a myth.

So my own approach now is: When it can’t be any other way (pension plan, ESPP, DRIP) I am effectively dollar-cost-averaging, but that does not mean I following the DCA system. If I have a lump sum available, I generally invest the lump sum.

The next part of this post may make this look like a link-farm, but rather than take my word for it, I suggest you look at the following links. I must admit that I’ve got an overweight of anti-DCA links, I’m sure you can find some more pro-DCA links if you want to see more of that side of the story.

First, a more or less neutral link:

• Dollar cost averaging (Wikipedia)

Links describing and extolling the virtues of Dollar-Cost-Averaging:

• Dollar Cost Averaging: A Technique that Drastically Reduces Market Risk
• Dollar-Cost Averaging (DCA) (from Investopedia. Investopedia is a Forbes media company; I’m surprised it doesn’t have a short for and against discussion of the subject)
• Dollar Cost Averaging: Slow and steady wins the race (from Motley Fool)

Against:

• Mathematical Illusion: Why Dollar-Cost Averaging Does Not Work (academic discussion, but stiil readable, I recommend it)
• Does Dollar Cost Averaging Work?
• Dollar-cost averaging’s not all it’s cracked up to be (USAToday)
• The costly myth of dollar-cost averaging (MSN Money)
• Dollar Cost Averaging Will Not Protect You

Some blog posts reactions on Dollar-Cost-Averaging, mostly against:

• Dollar Cost Averaging: A Poor Way To Reduce Risk?
• Dollar cost averaging and assumptions
• Does Dollar Cost Averaging Work?

I never thought I would actually post something about compounding and here I am, writing my second post. Well, first of all I thought it was such a well understood principle. As mentioned in my previous post, my wife recently came across an acquaintance who did not believe an example on compound returns she provided. The numbers were too startling.

If, however you are converted, this post titled “When Even The Power Of Compounding Can’t Save You” gives further insights on using compounding to reach a million dollars. It even contains Yet-Another-Einstein-Reference-To-Compounding (hereafter known as YAERTC). Besides the Einstein reference,  the post is good, especially at showing how reaching the first million, even using compounding, can take a while. Provided you can keep away from the money, compounding ensures that the second million arrives in your account up to six times faster.

The tables show how long it will take using different values for monthly contributions. The highest value, $1,291.66, represents the maximum monthly contribution Americans can make to certain tax-friendly investment accounts (401(k)s). With the current USD to GBP exchange rates and multiplying that value by 12, you get ~£7500, not far from the maximum amount you can contribute each year to a Maxi ISA here in the UK (£7000 this tax year, £7200 next tax year).

When mentioning compound returns, many quote Albert Einstein as having declared compound interest to be “the most powerful force in the universe”. It is an urban myth, but it seems to have taken on a life of its own, so I had no choice but to also mention the quote in this particular post .

I am fully converted to the principle of compound returns, and having teenagers I have frequently tried to teach it to them. I recently saw a very convincing example of compound returns and the advantage of starting to save as early in life as possible. The example compares two people, each putting aside the same amount of money per year. However, person 1 starts as a 20-year old and stops as a 30-year old but keeps the savings account. Person 2 starts at age 30 and continues until he/she reaches the age of 60. Person 2 will have contributed 3 times as much to the savings or investment account as Person 1, but Person 1 ends up with more money.

My wife mentioned the example to some acquaintances the other day, and some of them just wouldn’t believe it. Whilst compound returns IS obviously true, I started doubting the example, maybe the gains from 10 years of early contributed savings did not surpass the gains from 30 years of savings, maybe I was the victim of yet another internet-circulated urban myth.

So I created a simple spreadsheet, and the results are just in:

• At a return of 3.6% and above, the total gains are higher for Person 1 than for Person 2.
• At a return of 6.3% and above, the total result is higher for Person 1 than for Person 2.

If you want to see for yourself, or play around with some of the numbers, you can download the spreadsheet here.

I’ve found these descriptions of lotteries various places:

• Regressive taxes
• Taxes on fools
• Mathematical taxes
• Voluntary taxes
• Redneck retirement plan

But I particularly liked this post Why do poor people always win the lottery? which ought to put anybody of buying lottery tickets thinking they might strike it rich.

Many (most?) people live from pay-check to pay-check. They are more or less broke by the end of every month. Luckily, come payday they are back in the money. Unless of course there is an unexpected expense during the month, in that case you’re in real trouble.I used to live like that. I was doing a little bit better than most. I had a budget. In my budget I could see how much I was earning and what expenditure I had. The budget showed me that there would be a surplus at the end of every month. Great! I was obviously going to save that surplus. Problem was, there never was a surplus at the end of the month.

The book “The Richest Man in Babylon” taught me to “Pay Myself First”. Come payday, I pay myself something which is immediately transferred to a high-interest savings account. What is left is used for the other budgeted expenditures. Unless you belong to the category of people that just can’t control their spending, you will usually find that you are not missing the money you are paying yourself at the beginning of the month.

The high-interest savings account is obviously only a short term thing. Once there is enough to make it worthwhile, that money should be invested so it can work for you.

So how much should you pay yourself? Something is obviously better than nothing, but aim for at least 10% of your income.

Like most people, I was not brought up financially literate. Neither school nor my parents taught me about financial matters, and I’ve had to learn in the school of life. Luckily, I have been spared learning through making really awful mistakes, but I sure wish I had known what I know now at a much earlier age. I have on several occasions sat down with my children and introduced them to financial matters in the hope that they will start of understanding financial concepts and how it applies to their lives better than I did when I moved away from home.

Looking back, this is a list of the items that have helped me the most on my way towards financial literacy, and which I would recommend to anyone starting on a path towards becoming financially literate.

Quicken

A colleague introduced me to Quicken more than 10 years ago. In the beginning I almost religiously entered my income and spending regularly into Quicken and its graphs and reports enabled me to understand how my money was actually used and that was a real eye-opener. There were several categories of spending where my spending habits changed as I was able to see how much I was actually using on the different categories. Whether you buy Quicken, Money, another personal finance program or maybe even use a spreadsheet is not that important, the important thing is that you keep track of your spending.

The Richest Man in Babylon

This book couches its teaching of financial concepts in a story about some men in ancient Babylon which means I’ve been able to read it aloud to my children when they were not yet teenagers, and they liked it.

The most important concept learned from this book is the concept of “paying yourself first”.

The Millionaire Next Door: The Surprising Secrets of America’s Wealthy

This book is based on research into the profile of millionaires. The research found that the most common profile of a millionaire is an entirely different type of person than the media usually portrays. The book makes it clear that most millionaires are ordinary people like you and me, but they are people who control their spending. I may not become a millionaire, but I can live the same way these people can and at the same time have a go at becoming one. The insights gained from this book have helped me lead a financially literate life.

The 5 Lessons a Millionaire Taught me about Life and Wealth

A short and easy to understand book which distils financial literacy into 5 simple principles. So once you track your spending, and can see the benefit of paying yourself first and have gained an insight into the lifestyle real millionaires have, read this book and you have the tools to be financially literate.

Welcome to this new personal finance blog. For more on why the world needs yet-another-personal-finance-blog (yapfb), see the “About” page.