What is Formula Investing
Formula investing is a method of investing that rigidly follows a prescribed theory or formula to determine investment policy. Formula investing can be related to how an investor handles asset allocation, invests in funds or securities, or decides when and how much money to invest.
BREAKING DOWN Formula Investing
Formula investing takes most of the discretionary decision-making out of the investment process, which can reduce stress for investors and help them automate their strategies; investors simply follow the rules or formula and invest accordingly. A drawback of using formula investing is the inability to adapt to changing market conditions. For instance, during a period of extreme volatility, an investor may achieve better results by making a discretionary adjustment to their investment strategy.
An investor must make sure that the formula fits with his or her risk tolerance, time horizon and liquidity requirements for it to be effective. Dollar-cost averaging, dividend reinvesting and ladders are examples of simple formula investing strategies.
Formula Investing Strategies
- Dollar-Cost Averaging: This strategy involves buying a fixed dollar amount of an investment on a set schedule, irrespective of the investment’s performance. For example, an investor might have $12,000 to invest in a stock and decides to invest $1,000 on the first day of each month for the next 12 months. Dollar-cost averaging can help investors to build up their portfolios in a piecemeal fashion, adding small amounts of money over a consistent time frame. (For more, see: Pros & Cons Of Dollar Cost Averaging.)
- Dividend Reinvesting: Investors may set up a dividend reinvestment plan (DRIP) to reinvest dividends to purchase additional stock. This strategy has the advantage of compounding wealth, providing the company invested in pays consistent dividends. For example, assume an investor’s stock pays an annual 5% yield, and his or her stock holding has a value of $10,000. After year one, the investor reinvests the $500 dividend and now has a stock holding of $10,500. After year two, the investor reinvests the $525 dividend and has a stock holding of $11,025. The compounding effect continues as long as the investor keeps reinvesting dividends. This example assumes that the share price remained unchanged over the two-year period.
- Ladders: Investors use this strategy for fixed income investments, such as bonds. Investors purchase a portfolio of bonds with different maturity dates. By staggering the maturity dates, the short-term bonds offset the volatility of the long-term bonds. Cash received from maturing bonds is then used to buy additional bonds to keep the defined structure. (For further reading, see: Boost Bond Returns With Laddering.)