Are Small Payments Expensive?

When looking at investment options, a person with no savings can indulge himself in dreaming that some day, without effort, a lot of money will fall into his lap; and of course, sometimes dreams come true. But for nearly all of us, the only way we can logically expect to acquire capital is to accumulate it, bit by bit, with the assistance of wise investing.

Consistent saving is usually advocated on psychological grounds—forming a habit, making the sacrifice less painful by saving a little bit each time, and having the satisfaction of watching our capital grow. Many families, before new in­come arrives, are so thoroughly committed to installment pay­ments for things already bought and in use that they haven't a dime to spare for saving. The only possible way for such a family to save money is to set up an investment plan with a schedule of a fixed dollar amount they are obligated to pay on specified dates, so that meeting the periodic investment payment is just as firm a commitment as their other install­ment payments are. When considering your investment options, this is a viable alternative to delaying investment until more capital is acquired.

Until rather recent years, there was a scarcity of plans permitting the buying of high-grade investments with small, easy payments. But now a variety of plans are available to anyone doing a little searching.

In buying consumer goods, it is generally safe to assume that "easy payments" or "small, convenient installments" in­volve high costs. But in many types of investing small pay­ments add little or nothing to the cost, and on common stock they may even cut the cost. When looking at investment options this is important to consider. Why is it that small payments are an expensive way to buy such an item as an automobile, but can be a cheap way to invest? Here is the main difference:

When a customer takes physical possession of a car, after making only a down payment, the dealer, in effect, makes a loan to the customer of the full price of the car less the down payment. Naturally the dealer charges the installment buyer enough above the cash price to cover not merely the interest on the delayed payment but also the risk that the buyer will fail to pay as scheduled, plus a profit on this fi­nancing. Also, with the customer's attention focused on the size of the monthly payment, so that he loses sight of the total cost, probably the cost is further raised by adding unimportant extras to the car.

In contrast with the automobile purchase, suppose a man wants to invest in U. S. Government E bonds. He cannot take physical possession of an E bond until he has paid cash for it. But for one bond of minimum size he needs only $18.75, and on paying that amount he owns one complete bond, with exactly the same scheduled rate of appreciation in value, each six months, as on the largest size of E bond. Buying an E bond is an installment only in the sense that the buyer may intend to buy more bonds as soon as he has the cash avail­able. The only reason we mention E bonds alongside install­ment buying of a car is to bring out how different the two transactions are, although both involve small, easy payments.

Banks customarily accept savings deposits of most any size, and the rate of dividend paid is the same on all sizes of de­posit, above perhaps some such minimum as five dollars.

In corporate stock, the unit of ownership is always one share, but the market value of a share varies considerably among the companies. On the great majority of issues of common stock, a share is priced below $50, many below $25. So not much capital is required to own a share, and a one-share owner receives just as much dividend per share as does any larger owner of the same issue. But on stock publicly owned, a man's buying or selling shares normally involves paying the fee charged by a stockbroker or dealer, and on most issues, this fee bears heavily on a small transaction. This is important to note when looking at investment options.

Fortunately, on shares of the mutual-fund type of invest­ment company, the system of charging by dealers is quite dif­ferent from that mentioned above. At any one time the cost to an investor per share issued by most of these mutual funds is the same for any number of shares, except for a moderate scale of price reduction on very large amounts, starting usu­ally at $25,000. And when an investor wants cash for his shares, the redemption value per share is the same, regardless of quantity.

Paying off a mortgage by amortization is another type of your investment options wherein payments can be small and also sensible. A mortgage is a long-term debt, and generally when a customer takes possession of purchased goods, with an arrangement that he will take years to finish paying, he must expect to pay considerably above the cash price. But on a house and lot the commercial value does not depreciate at any such speed as with an automobile, and quite possibly the value may rise. So whoever lends money on a real-estate mortgage takes less risk, and need not charge as much as for other loans on consumer purchases, especially if the down payment is substantial and the house is so located and built that its commercial value is apt to hold up well.

Unlike the examples given above, in many investments the rules are unfriendly to small payments. An investor needs to be on guard against easy generalization on this subject.

Most contracts offered by life-insurance companies include some element of investing. Payments on these contracts can be conveniently small, but in contrast to E bonds, a payment is treated by the company as just one installment on a pur­chase, whose payment is spread over many years, with high extra charges for small, frequent payments and considerable penalty for failing to continue paying.

On bonds, aside from U. S. savings bonds, the minimum amount is usually $1,000. On corporate stock, outside of the mutual funds, the system of broker's commission charges acts as a penalty on small purchases and sales.

Steady Share-Buying

In buying an equity whose market price varies consider­ably over the years, the habit of consistent, long-term saving of small amounts has pronounced advantages, in addition to the more obvious effects on saving versus spending mentioned at the beginning of this chapter. In principle, these extra advantages apply to any type of equity, but often the minimum practical unit is too expensive for frequent buying by an investor with an ordinary amount of savings. On the other hand, a man saving as little as $10 a month is not barred from steady buying of corporate stock, for he can take his choice among plans offered by several mutual funds.

Probably the main drawback to steady buying of stock when looking at investment options is the absence of drama. Undoubtedly speculating is the excit­ing way to invest, but it involves prophecy on future prices. If a reader has confidence in his ability to gamble successfully in stocks, he is wasting his time in this chapter. Here we go to the other extreme, placidly buying a few shares periodically, whenever savings are available.

If a man buys stock without regard to the current price, what assurance can he have of obtaining a reasonable cost? Roughly the answer is that the more steadily and uniform­ly he buys, the better his chance.

Whenever an investor buys stock he pays today's price, and he never knows whether the future will show that today's price was low or high. By buying regularly, he automatically pays prices close to the highest, the lowest, and others ranging all the way between the two extremes of the prices that are offered during the period of time he is buying. The average of the prices he pays is fairly sure to be close to the average of all those quoted during the period.

Although the price of a stock may change considerably in a few months, the major changes in price, especially on a broadly diversified fund, take several years to develop. The highest price quoted at any time during a given year may turn out to be low compared to the lowest price offered during the next several years, and vice versa. For a share of a large, diversified common-stock mutual fund during 1949 the highest price was 29 per cent higher than the lowest price during that year. But a year later, the price level had risen until, in retrospect, the highest price of 1949 looked low, and the rise continued until, during 1956, the lowest price was more than twice as high as the highest in 1949. Then the tide turned, and late in 1957, the price dropped to 19 per cent below the lowest of 1956.

Assuming that future price fluctuations will somewhat re­semble those of the past, an investor needs to continue buy­ing regularly for at least five years in order to cover a sufficient price range so that the average of the prices he pays is pretty sure to be reasonable. Spreading purchases over enough years is much more important than the timing within any one year.

Now let us examine more closely what is meant by "average." Suppose a man made just two purchases of a certain stock, paying $20 a share the first time, and $10 the second time. The average of those two prices is $15. Each time he put in the same amount of cash, $100, so that when the price was $20 he got five shares, and when the price was $10 he received ten shares, a total of fifteen shares for $200. His average cost, $200 divided by 15, was $13.33, and this was considerably less than the average price of $15.

From this example it is obvious that by investing the same number of dollars each time, a man is bound to come out with an average cost lower than the average of the prices he pays. This automatic advantage is called "cost averaging." No matter whether the average of the prices a buyer pays is high or low, cost averaging works in his favor. Of course, it is better also to buy steadily and long enough to obtain a good average of prices.

If a man is saving with the intention that some day, when his salary is reduced or stopped, the income from his capital will be big enough to support his family, then he had better form a fixed habit of reinvesting all income from investments and, as long as his salary permits, also of saving some of his pay. The importance of this attitude grows as a man ap­proaches retirement age and his income from capital is grow­ing.

Suppose a middle-aged man's annual salary is $10,000, and his income from investments is $2,000. He thinks of his in­come as being $12,000 a year, and that $1,500 is enough to save. But what will happen to his family's standard of living when his salary stops, and his income from investments has risen, let us say, to only $3,000? It would be so much safer for him to think of his income as being only from his salary, out of which he should continue to save a substantial amount.

Avoiding the receipt of cash income from investments is a comparatively painless way to save, because you don't see the money! In some forms of investment, not paying income in cash has long been the rule. On a savings deposit, a bank adds a dividend to a depositor's balance, not paying cash un­less he asks for it. An E-bond owner receives income only in the form of added value when he cashes part or all of a bond.

On most other bonds, cash interest is paid periodically. Also, dividends on most corporate stock issues are paid only in cash. On these bonds and stocks, an owner wishing to re­invest must act individually, using the cash income to buy more bonds or stock. But in nearly all of the mutual-fund in­vestment companies, a stockholder can give the company standing instructions to use his dividends to buy more shares instead of sending him cash. This is one of several devices mentioned later in this chapter to simplify the buying of shares in mutual funds.

In practice, the idea of steady share buying often does not work out so well as it sounds. An investor needs to realize that in order to obtain the best results from systematic buy­ing, he must be able to save and invest just as many dollars in a year when stock prices are low as when they are higher. This may be impossible for him, because poor business con­ditions cause his income to drop at the same time that stock prices are down. Also, he must have the backbone to continue buying when the stock-market atmosphere is gloomy. These drawbacks are not an argument against the principle of steady buying; we mention them here merely as a warning against expecting too much.

Penalties and Life Insurance

Here we go into further detail on the ways offered by mutual funds for purchase of their shares.

In nearly all mutual funds an investor can order any num­ber of shares above a low minimum, pay for them at the currently asked price per share, and receive a certificate of ownership. This is the old-style method of buying, and it still suits a good many investors. Each purchase is a complete transaction, and a buyer gives no hint as to when or whose stock, or how much, he intends to buy next time.

But the old method is cumbersome for small payments and is confusing to investors not accustomed to buying anything whose price fluctuates continuously. Also, many buyers like to be more or less committed to a program. So nearly all mutual funds now offer the option of a different way of buy­ing their shares. While these plans differ in several respects, it seems they all agree on these minimum rules:

1. An investor signs an application form, whose accept­ ance by the company puts the plan into operation. This form says he is going to make frequent purchases of the fund's shares; but in some plans, this is merely a statement of inten­tion, with no obligation.



2. He sends in dollar payments, without needing to know the current price per share.



3. At each payment, the company sends him a receipt showing he has bought so many whole shares, plus whatever fraction of a share uses up all of his payment at the current price.



4. The company keeps track of his total purchases to date under the plan, but does not send him a formal stock certifi­cate unless he requests it, or the plan is ended. This relieves him of record-keeping, also of safekeeping of stock certifi­cates.



5. He can cancel the plan, or redeem part of his shares, at any time.



6. He has the option of giving the company standing instructions not to send him dividends in cash but to buy new shares for him. A stockholder can arrange separately for this automatic reinvesting of dividends without joining the rest of the plan.

In some mutual-fund plans, these rules cover all of the main points. These plans leave an investor completely free to send in any dollar amount, whenever he chooses. Many other funds set a minimum size of payments, typical amounts being $250 to the initial payment, $25 or $50 on repeats. Usually an investor can build up to the initial minimum by buying shares in the regular old way until he has enough to join a plan. No extra charges are involved in the plans mentioned thus far.

Other plans have much stricter rules, and many of them offer life insurance as an option. An investor signs up to pay a certain uniform dollar amount monthly for ten years, the minimum being $20 the first month and $10 thereafter. The company reminds him each month that another payment is due. Out of an investor's payments during the first year, some companies take heavy selling expenses before buying shares with the remainder, so that if he drops the plan in the first year or two, he suffers a severe penalty. That is why we call them "penalty plans." Even if he completes the ten-year pro­gram on time, with no misses, the total fees charged are high­er than on non-penalty plans, and the extra fee is larger on small payments such as $10 or $20. (Incidentally, on an ordi­nary life-insurance policy sold direct by an insurance com­pany, the penalty for early quitting is more severe than in the mutual-fund penalty plans.)

The merit of a penalty plan seems to be mainly psychologi­cal. It appears that many a man knows or fears that when he adopts a savings program, the chance of his sticking to it is better if the selling organization sends him a reminder every month and penalizes him if he quits. In fact, in a family that chronically is heavily involved in installment payments for goods received, probably the only possibility of saving any money is to sign up for a penalty plan of investing. If joining a penalty plan causes a family to save a larger total amount, or if it induces them to invest in stock more consistently, thus getting the benefit of fair average, prices and cost averaging as explained earlier in this chapter, then for them the penalty plan may be well worth the extra fees charged.

As part of a plan for buying shares in a mutual fund, sev­eral companies include an option for an investor to take out life insurance, so that his death will not spoil the program of accumulating stock for his family or heir. To enable a mutual fund to make this offer, it arranges a group term con­tract with a life-insurance company. The charge per $1,000 of insurance in force is the same for all ages of share buyers that are accepted as standard insurance risks. An insured share-buying plan must have a rigid schedule, a uniform dol­lar amount to be paid in periodically for a fixed number of years.

Suppose an investor signs up to put in $50 each quarter year for ten years, a total of $2,000. The amount of insur­ance on this plan starts at $2,000 less his first $50 payment. Thereafter, while he lives, the insured amount drops $50 each quarter year, reaching zero at the end of ten years, and the charge for insurance goes down proportionately. Suppose that he dies after making twenty-eight payments, leaving $600 un­paid. The insurance company steps in and pays this $600 to the mutual fund, thus completing the investor's plan. The mu­tual fund delivers to his estate a stock certificate covering the shares bought with the whole $2,000 plan.

The main peculiarity of this insurance is that death pro­ceeds paid to an insured man's estate are in the form of shares of stock. Provided an investor's family receives shares of stock rather than any of the fixed-dollar settlement op­tions offered by life-insurance companies on individual poli­cies, this plan may be quite useful. Aside from insurance on mortgage amortization, it seems to be the only way a man can buy a package combination of life insurance and a well-invested savings fund with protection against inflation.

As in buying anything else on easy payments, an investor needs to be on guard against paying too much attention to the installment arrangements, to the neglect of other features of a mutual fund. Whatever type of buying plan an investor wants, enough mutual funds offer that type so that, with some searching, an investor can probably find at least one fund that suits him in other respects as well as in its easy payments.

Wiesenberger's Investment Companies gives a convenient separate list of mutual funds offering share-buying or "accu­mulation" plans. The Mutual Fund Directory, issued by In­vestment Dealers Digest, mentions buying plans in connection with other data on each fund. And of course, each fund furnishes free information on its own plan.