This article was last updated on December 2
I hope you didn’t reduce your 401K or other retirement account contributions when stock prices and markets tumbled earlier this year. Even though the value of your current 401K or retirement plan probably fell over this time, in the long term the power of dollar cost averaging and recovering/rising markets would have ensured that your portfolio will be worth more than it would have been if you stopped your contributions when things got rocky. Here’s a simple example that illustrates this concept
Joe had a 401K portfolio of $100,000. Assume each stock (or fund) unit was worth $1000 in September. So he had 100 stock units. He used to buy 1 unit every month when he got paid, which cost him $1000. However with the fall in share prices, the unit price dropped to $500. So Joe’s portfolio is now worth $50,000. Joe is not very happy but is a long term investor. So he keeps investing the same amount every month, but now gets 2 stock units for the same price.
By June the following year, 9 months later, he has 100 + 2×9= 118 units. With a recovering stock market (just like we are seeing now), the units are back to being worth $1000 again by year end. So Joe’s 401K portfolio of 118 units are now worth $118,000.
By the end of the next year (20 months later) with the economy growing again and optimism in the markets the units are now worth $1500. So Joe’s 118 units are now worth $177,000. So in the medium term, even though the stock unit price fell, the investment turned out okay as the price recovered. But what if Joe had stopped investment when things got rocky?
If he stopped investing way back in September when the stock market tumbled, he would only have the original 100 units and they would be worth $150,000 based on the final price in the example above. So, Joe’s retirement portfolio is $18,000 worse off (less $9000 for the cost of the 18 units) by not keeping up his contributions. This example is very basic and is based on assumptions like the market recovering – which I would be very confident of given historical trends. Still you get the idea and power behind dollar cost averaging. You can get more bang for your buck when markets are down and magnify the gains when markets rise.
Unless other circumstances prevent you from maintaining your regular retirement account contributions, don’t stop investing when things get rocky. To ensure a comfortable retirement aim to commit 10% to 15% of your salary in a 401K or other retirement account. Best of all your contributions will be tax free and most likely accompanied by a company match.