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.
- With formula investing, a market participant follows a structured plan that determines factors such as asset allocation, types of securities invested in, or the amount and frequency of investments.
- Some examples of common styles of formula investing include dollar-cost averaging, dividend reinvesting and ladders.
- Formula investing is appealing to market participants who find active investing stressful or overwhelming; formula investing is structured and consistent.
- The downside to formula investing is that it doesn't leave much room for an investor to make changes to adjust to unforeseen market or economic changes.
Understanding 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 may simplify the investment process for inexperienced investors or those who lack the time to actively manage their accounts; however, the risk is that a formula investor can't react fast enough to changes in the market or the economy.
Formula Investing Strategies
- Dollar-Cost Averaging: This strategy involves buying a fixed dollar amount of an investment on a set schedule, regardless of how the investment performs. For example, a market participant invests $1,000 in a particular mutual fund on the first day of the month, every month for a year, ultimately investing $12,000. Dollar-cost averaging helps to build a portfolio in a piecemeal fashion, adding small amounts of money over a consistent time frame.
- 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 pays consistent dividends. For example, an investor holds $10,000 in stock that pays an annual yield of 5%. After a year, the investor reinvests the $500 dividend and now has stock holdings of $10,500. After two years, the investor reinvests the $525 dividend and has holdings of $11,025. The compounding effect continues as long as the investor keeps reinvesting dividends. This example assumes the share price stayed 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.