Money management is a very important topic. Yet almost nobody does it. Well, no investors anyway. Short-term traders do it all the time, but investors? Very few.

If you’re reading this, you probably have money invested in the stock market. And if you’re like most investors, you’re probably doing a few things incorrectly (perhaps more than a few things). And you probably know you could be achieving far better returns than you’re getting right now, but the big question on your mind is, “How do I take my investing to the next level?”

Well, if you’re already selecting fundamentally strong stocks with wide economic moats, purchasing these stocks at prices that ensure a sufficient margin of safety, diversifying amongst uncorrelated stocks, allocating money in each stock according to a proven plan and rebalancing when necessary, then the next level is proper money management.

So what exactly does that mean?

Short-term traders and gamblers are extremely familiar with the concept because they can’t afford to lose all their money on one trade or on one bad bet. So they carefully control how much money they will bet at any given time.

A trader might decide not to place more than 2 percent of his money on any single trade or a poker player might use the Kelly Criterion to manage how much to bet on each hand based on the pot size and the probability of winning.

This is money management.

In fact, everyone who invests in the stock market does it, although the vast majority don’t realize they’re doing it and, because of this, they do it poorly.

Long term investors don’t usually think they need a money management strategy because they buy and hold. And since the stock market (and stocks in general) tends to go up over time, the need for a good money management strategy is somewhat masked.

However a good strategy can improve your profits and minimize your risk; so it’s worth looking at if you want a portfolio that is as efficient as possible.

So let’s look at a couple of strategies that long-term investors can use.

Before I begin, however, I’ll remind you that you should already be investing in solid stocks before using any money management method. If you invest in poor quality stocks, you’re building your financial future on a weak foundation and everything you do after that will be precariously balanced, at best, and have a very good chance of collapsing like a house of cards.

So with that important warning out of the way, let’s press on.

The idea behind proper money management is to minimize risk. Stock prices are uncertain. You don’t know, from one day to another, which way they will move. This leads to risk. If you purchase a stock and its price falls, you lose money. If it falls a lot, you lose lots of money.

It’s a risky business.

A money management strategy gives you guidelines so you know what percentage of your entire investment funds to put into the stock market at a given time, because it’s always a good idea to keep some cash on hand.

But how much do you keep? How do you allocate your money to stocks over time?

The best known strategy is Dollar Cost Averaging (DCA). Most people have at least heard of the term. Its method is to invest a fixed amount periodically over a specific time period. For example, if you had $12,000 to invest, rather than investing it all at once, you could decide to invest $1,000 a month for the next year.

Since you expect stock prices to fluctuate, that fixed amount of money will buy a different number of shares each month. When share prices are higher, you’ll buy less shares; when they’re lower, you’ll buy more.

The goal is to lower the average cost per share and spread your risk over a longer period of time.

The nice thing about DCA is it’s easy to implement. If you’re investing in mutual funds you can have the fund company automatically deduct a fixed amount from your bank account for you. If you invest in individual stocks, you simply spend a few minutes each month purchasing shares (incidentally, you can use these new inflows of cash to rebalance more effectively too).

The downside of DCA is, being time-based, it doesn’t have you investing most efficiently. There’s no reason to believe purchasing a fixed dollar amount of stocks at a random point in time will have you buying low enough. In fact it usually doesn’t. And when prices get too high, it just keeps buying.

Still, it can be better than investing all your money at one random point, such as when you decide to start investing, and hoping you chose a good time.

Fortunately there is a better way: Dollar Value Averaging (DVA).

Unlike DCA, not many investors are familiar with DVA. So here’s a quick overview.

The idea behind DVA is to ensure your portfolio value increases by a set amount regardless of how your stocks behave.

As an example, suppose you’d like to have $1 million in 25 years and you currently have $100,000 to invest. You could choose to invest $60,000 now and keep $40,000 in cash. That means you’ll need to achieve a 12% annual return (on the $60,000) over that time period.

However there is no guarantee you’ll get this rate each year. You might achieve it in one or two of the years, but in other years you might get more or less.

When you get less (because the stock price went down), you add enough money to purchase enough shares to bring you up to what your portfolio should have been if you had achieved that 12% return for the year.

On the flip side, when your stock price rises to a level that returns more than 12%, you withdraw cash to bring your portfolio down to where it should be based on your 12% annual goal.

So when your stock does well, you contribute less at the end of the year (or even take money out) and when it does poorly, you contribute more to make up the difference.

To continue the example, let’s say you purchased a stock selling at $60 per share with your initial $60,000 investment (so you would have 1000 shares).

Since your goal after the first year is a 12% return, you expect your portfolio to be worth $67,200 after year one. But suppose the stock price falls to $55. Your portfolio value is now $55,000 (or $12,200 less than what it should be).

Therefore you would add $12,200 to your portfolio (from your $40,000 cash reserve) and purchase 221 additional shares at $55 each (you would then own 1,221 shares).

Now suppose shares rise to $62 after year two. Since you own 1,221 shares, your portfolio value is $75,702. However your year two portfolio value should be $75,264 (that is, $60,000 x 1.12 x 1.12). Therefore you have $438 more than your goal at that point in time. So you could sell 7 shares to bring you down to your goal.

Then you simply continue the process until 25 years have gone by. At that time you’ll have your $1 million. Note however your actual return will depend on how your stock performed. If it performed very well, your actual return might be significantly more than your 12% initial annual target. That’s because you will have taken money out over the years.

On the other hand, if your stock didn’t perform as well, your actual return could be significantly less than 12% because you were forced to add more money over the years (perhaps even more than the initial $40,000 you kept back).

If your stock averages a 12% annual return, then your additions and withdrawals will cancel each other.

The downside to DVA is, obviously, it’s more work than DCA (although with spreadsheets and software it’s not that much more work).You might also have to sell shares, so there may be tax consequences involved.

However the biggest drawback is you have to have sufficient cash flow to cover years where your stock price might have dropped severely. In those years you would need to come up with enough cash to top up your portfolio. It’s possible to deplete your initial cash reserve and then have to dip into other sources to make up the cash deficit.

Still, in volatile times such as these, it’s nice to have cash on hand and have a good strategy for deploying it into the stock market over time.

Super investor Warren Buffett has been known to sit on huge piles of cash for long periods of time until the market gives him what he’s looking for. After all, having cash on hand to take advantage of solid stocks selling at bargain prices is an excellent way to achieve superior returns in the stock market.

And a good money management strategy can go a long way in helping.

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