How Investors Who Practiced Dollar Cost Averaging Were Richer Within Only 2 Years of the Credit Crisis Meltdown
Citing data provided by Vanguard, one of the premier mutual fund and 401(k) providers in the world, The New York Times recently reported that 60 percent of 401(k) accounts now have more money in them than they did before the stock market crash and worst recession since the Great Depression began two years ago.
That may not seem possible given that the Dow Jones Industrial Average collapsed from 14,000+ to 6,000 and has only made its way back up to 10,000. For those who know how dollar cost averaging, dividend reinvestment, and compounding work, this isn’t surprising. You’d never know that, though, due to the incomplete information provided by the financial news networks, magazines, and newspapers.
Dollar Cost Averaging and 401(k) Balances
The average 401(k) investor doesn’t realize that substantial research has shown 99% of real, inflation-adjusted returns come from reinvested dividends. That means that changes in the value of your mutual funds are almost meaningless. Over time, the compounded value of your account as a result of plowing dividends back into additional shares of the fund, is where the real money and wealth originates. When coupled with dollar cost averaging, and the leverage you get from an employer’s 401(k) match, the wealth that flows onto your balance sheet over the years be astounding.
Here’s how it would work. Imagine you are employed by a regional hospital that offers 100% matching on the first 5% of salary you contribute to your 401(k) account. You earn $50,000 per year and contribute 20% of your paycheck to your retirement fund. That means that each year, your contribution consists of $10,000 deposited by you, plus $2,500 in matching funds from your employer ($50,000 x 5% = $2,500 x 100% matching = $2,500). This equals a grand total of $12,500 deposited into your 401(k).
This is important: By saving the $10,000, you not only got a tax deduction of as much as $2,500, you received a $2,500 matching contribution from your employer. Combined, this represents an instant 25% return on your money in extra cash deposited into your 401(k) and an additional 25% return in the form of lower taxes, meaning you will have more in your paycheck as a percentage of gross pay than you would have without the 401(k) contribution for a total combined 50% return on money. You could literally park the cash in Treasury bonds and make more by retirement than you could from virtually any other source due to these dual factors. People who criticize the 401(k) plan often foolishly ignore this source of “instant” income. If the stock market collapsed 50%, your account would fall to $6,250, representing a loss of only 37.5% of your money. Likewise, if the market went up 50%, your account would have a value of $18,750 ($12,500 + 50% gain = $18,750), representing a return of 87.5% on your money, that is, the actual $10,000 you deposited.
When you combine the inherent leverage you get on your money through the employer match and the tax deduction with the benefits of dollar cost averaging, the results are breathtaking. As the stock market crashes, your regular contributions, combined with reinvested dividends and employer matching, buy far more shares of stock. During the Great Recession and total market collapse in March 2009, when investors watched the Dow Jones Industrial Average fall by roughly 43%, their regular investments were buying more absolute shares of stock in the Dow components, such as General Electric, Johnson & Johnson, McDonald’s, Microsoft, and Coca-Cola. As a result, it didn’t take long for the cost basis of the 401(k) account to fall rapidly, lowering the break even point.
When stocks finally recovered and the Dow reached 10,000, it was still 28.6% below its high. Yet, the investors who continued to follow the rules and dollar cost average had more absolute money and dollars in their account than they did before the crash. The months when the market was in the tank allowed them to acquire shares at lower prices, setting the stage for profits when even a modest recovery came.
How You Can Use the Power of Dollar Cost Averaging In Your Own 401(k) Plan
To get the same results over long periods, of time, you only have to follow three simple rules in your own 401(k) plan or other qualified retirement account such as a Roth IRA or Traditional IRA. These are:
- Always max out your 401(k) contribution to the point of your employer match. This provides you an instant, risk-free return that crushes everything available anywhere in the world. By simply saving money, you’re instantly offered a 25%, 50%, 100%, or 200% return, depending upon how generous your employer retirement plan is.
- Continue making regular contributions throughout the year, avoiding lump sum investments. This is the heart of dollar cost averaging. You need the regular purchases, over many years, to smooth out your overall cost basis, taking advantage of market dips, or better yet, full-fledged crashes.
- Instruct your retirement plan provider to have all dividends reinvested into the fund that distributed the dividend. That way, you can get the dollar cost averaging benefit from reinvested dividends as well as your contributions and employer match.
That’s it. It really is a beautiful, simple model that has continued to work, despite foolish, undisciplined investors panicking as their account balances fell. Don’t be one of the idiots who cash out at the wrong time. You’re better than that. Take advantage of market opportunities, use the free money your employer offers, and let the power of compounding do the heavy lifting.