How Young Americans Can Profit From Today's Economy

Economy got you down? Well then chin up, young folks! You haven't got as much of a reason to worry as your older neighbors do. In fact, today's down market could have an incredible positive impact on your retirement if you play your cards right! I'm going to show you why you shouldn't beat yourself up about the nightmarish economy, but rather why (and how) you should invest. But be careful -- this is by no means a free pass to completely overhaul your personal financial plan (if you have one). My core values still stand: get out of debt, don't spend too much, and save your money. Let's get started.

Random optional side-notes:
First let me say that conspiracy theorists and skeptics and hard-core political enthusiasts are welcome to give me their comments about how the bailout and/or the election of a Republican/Democrat will doom us all. They may think that capitalism as we know it is over and before we know it, the government's interest in our financial institutions will create a socialist (or even communist) state and my words will be rendered irrelevant. Well, I hope that doesn't happen. But if it does, it's completely out of our control. The purpose of this post is to help average young Americans take advantage of this economy so they will benefit later in life. Future relevancy aside, this post assumes that the economy and government will function in the future as it has in the past.

On another side note, if everyone followed my advice and became completely debt free, the nation's economy would actually crumble. But don't worry -- it's impossible for an entire nation to become debt free. There is literally less money out there than there is debt. Sounds crazy, but it's true. :-)

Today's economy could actually help today's youth, and this theory is partially proven with the principle of dollar cost averaging. Essentially, the principle states that an investor's exposure to risk (risk of losing your money, that is) is reduced by buying investments incrementally instead of in one big lump sum. This works because in the short term, the stock market fluctuates frequently and unpredictably. So by buying stocks incrementally, you spread out your investment, buying in small batches for varying prices. On the other hand, the long term market is very predictable and its fluctuations are uncommon, minimal, and easily spotted. As you know, the idea of investing in stocks is to "buy low and sell high." In the short term, because it is difficult to know when you're at a peak and when you're in a valley, it's better to just keep buying a little bit at a time; sometimes you buy at the short term peaks and sometimes you buy at the short term valleys. In the end, you end up buying stocks for a dollar cost that is an average of its short term peaks and valleys.

Let's look at an example of short term fluctuation. You have $1,200 sitting around that you can invest in the stock market. Sure, you can take it all and invest it immediately, but it would be better for you to invest $100 it each month for the next year. Or even better, $50 every two weeks.

If you had invested that $1,200 in a mutual fund last October in one fell swoop, you probably would have lost quite a bit of your money (the Dow was at 14,000 last October and is at about 9,000 today). Let's say you bought the stock at 10 dollars per share -- 120 shares total. Let's also assume that because of the poor economy, the market has gone down 3% each month for a year (a realistic estimate given our recent history). So at the end of a year, your 120 shares would be worth about $912 -- about $7.60 apiece .

Now let's see what would have happened if you had invested $100 per month instead of putting it all in at once. In the first month, you would have bought 10 shares ($100 investment/$10 share price). But in month two, you would have been able to buy more shares with that money. Because the market had gone down, that stock was selling for $9.70. The next month, it would be selling for $9.41, and so on. By investing $100 per month for the full year, because of the discounted price, you would end up with 143 shares instead of 120 -- 19% more.

By investing incrementally, sure, you still lost money, but you also bought 90% of your stock for less than you paid for it when the Dow was at its peak a year ago. Because the market has gone down in the short term, the average price that you paid for that stock has also gone down. But because the market always goes up in the long term, you'll be better off when you eventually sell your stock because you will have a lower average cost per share and therefore, more shares. And the more shares, the better. When the stock eventually goes back up, you'll have 19% more money. When the stock pays a dividend, you'll get dividends for 19% more shares. More shares equals more money.

Of course, this theory goes both ways. Dollar cost averaging minimizes your short term gains as well. But if you want to guarantee your success in the stock market while maintaining your sanity, you need to give up on the notion of becoming a millionaire overnight or being the next Jim Cramer. Yes, dollar cost averaging will minimize both short term losses and gains, but it also ensures that your long term benefits aren't spoiled by the unpredictable daily/weekly/monthly peaks and valleys of the stock market.

Short term fluctuations are impossible to predict unless you've got the research budget of an investment bank. But in the long term, it's much easier to spot your "elevation" and buy when you're in a valley. Since 1978, there are only a few very obvious valleys. There was one in the late 80s, one in the late 90s, one just after September 11th, one in 2003, and one today. Today, stocks are cheap. This stinks for retirees that need to cash out to pay their mortgage, but it's wonderful for younger Americans that are just starting to save.

Just as it's true that short term ups and downs are unpredictable and should be handled with caution, it's also true that long term growth is quite predictable and its ups and downs can be more easily exploited. In the long term, when the market is growing quickly, it becomes proportionately more difficult to make a buck. But in days like these, when the market is down, it's the perfect storm for young folks to buy low and eventually sell high.

Those that understand the principle of dollar cost averaging and incrementally invest will minimize their short term losses (and unfortunately, short term gains, too). And those who, in the long run, slow their investing when the market is up and hasten their investing when the market is down (like today) will retire younger and more quickly enjoy a financially independent lifestyle than their get-rich-quick peers.