On May 23, 2012, Yahoo Finance posted an article by K. W. Callahan explaining why he is no longer funding his retirement account. Here is a snapshot of Mr. Callahan’s article.
Mr. Callahan has a business degree from the Indiana University Kelley School of Business. Unfortunately, he seems to have forgotten much of what he learned in business school. There are many misconceptions about the way the equity markets work. But, this post concentrates on the power of dollar cost averaging and how Mr. Callahan has missed out on a significant opportunity to grow his retirement savings.
Mr. Callahan explains that he stopped contributing to his 401K in late 2007. At that time, his retirement account balance was about $38000. He correctly points out that his balance was only $33000 in late 2011 – almost 5 years later.
Assuming he makes about $50000 per year, a 3% contribution would have amounted to $125 per month. If he had saved $125 per month in a non-interest bearing account, he would have added $7500 to his savings over the course of 5 years. That would have brought his retirement savings today up to around $40000.
But, a better strategy would have been to invest his 401K in a diversified basket of securities reflecting the total market value, such as the iShares Russell 3000 Index Fund (IWV), and keep contributing. If Mr. Callahan had done this, he would have had around $45000 as of June 1, 2012.
The reason is simple. With regular contributions at set intervals, investors are able take advantage of low points in the market. For example, purchasing $125 could have bought 3.15 shares of (IWV) on February 2, 2009 — at the low point of the market. A similar investment of $125 on April 1, 2011, would have purchased only 1.56 shares. Catching the up’s and down’s of the market by purchasing set amounts at regular intervals allows investors to accumulate more shares when prices are low and less shares when prices are high. This is dollar cost averaging.
Obviously, there were months that such a strategy would have left Mr. Callahan’s account with less than $38000. But, over a reasonably long period of time (years, or decades), dollar cost averaging using a diversified basket of securities has historically produced much better yields than buying securities all at once and then holding them. And it has produced better results than government bonds, real estate, gold, or other investments.
The lesson is to keep investing a set amount regularly in a broad range of investments. Never give up.