What should I do about my 401(k) contributions?
COVID-19 has taken the United States and the world by storm. Businesses have closed their doors, toilet paper has flown off the shelves, and millions and millions of Americans are working from home. The fear surrounding this virus along with the economic impact have resulted in more than a 35% decline in value for the Dow Jones Industrial Average (from 02/12/2020 to 03/20/2020). We have received many calls from clients concerned about their retirement accounts, and many are wondering what they should do. Some are asking if they should even be contributing into their accounts right now, when many are seeing 10%, 20%, even 30% less than they had just a couple months ago.
Even though we are keeping a close eye on the developments, we cannot predict what will happen tomorrow or next week, or what new developments will occur. What we can do however, is look at history and see what the markets have done during and after similar declines in the market, and what investors might want to consider. Each investor is different, has different goals, different tolerance for risk and different time horizons, but one thing each investor can do is dollar cost average.
Dollar Cost Averaging is defined as, according to Investopedia, an investment strategy in which an investor divides up the total amount to be invested across periodic purchases of a target asset in an effort to reduce the impact of volatility on the overall purchase. What that basically boils down to, is investing a set amount consistently in the same investment over a certain time period, instead of investing all at once. An easy example to think about is investing $100 every month for a year, instead of investing $1,200 all at once. Let’s look at an example of an investor who began investing at the peak before the 2008 financial crisis, which was October of 2007, and utilized dollar cost averaging. Let’s call our investor Sally:
Sally began investing in 2007 with $50 each month invested into an S&P 500 index fund. The key to dollar cost averaging is the periodic investment. Sally Invested $50 each month, through the good and through the bad. At worst, Sally’s account was down about 36% in February of 2009. By continuing to push through, by September of 2014, Sally had seen a 56% gain, or an average annual return of about 6.5%. If Sally were to take that same $50 and saved it in cash, on September 1st of 2014, she would have $4,200, which is 7 years of $50 monthly savings. That same $50 that was consistently invested into the market throughout the same time period would be worth $6,563.97, which is $2,363.97 more, or 56%. Remember, Sally began investing at the peak of the market, her timing was not the best, but she stuck it out and continued through with her long-term plan.
Sally Investing into The Market
Sally Saving in Cash
This is a hypothetical example for illustration purposes only.
Business Insider/Andy Kiersz, data from Yahoo Finance
This chart shows the percent gain or loss of Sally’s account from the inception in 2007 to September 1st of 2014, based on difference between if she held it in cash or invested it. As you can see here, she was down over 35% in early 2009. Sally could have very easily given up on her plan in 2009, and moved to cash, but she didn’t and by doing so, she was rewarded with a 6.5% average annual return.
The purpose of this example was to show the power of dollar cost averaging in the real world. Another way to think of it is: You have $1000 to invest into a fund that is priced at $50. You buy 20 shares today assuming no trading costs, the entire amount is invested. Your cost basis is $50 per share. Instead, using dollar cost averaging, you could spread that $1000 out over 10 months, with $100 buys each month. The share price may be $52 one month, or $46 another, and by the end of the 10 months, using a hypothetical example, your cost basis is $48. By continuing to buy over time, you do not try to time the market. Buying low and selling high is the ideal scenario, but it is very difficult, and could end up costing you money in the long run. Using dollar cost averaging you are avoiding market risk by not trying to time the market and flattening out the ups and downs by consistent purchasing.
Now thinking about your 401(k) at work, you already are dollar cost averaging and you may not even know it! By continuing to contribute each pay period, you are doing exactly what Sally did which was continuing to follow her plan and buy shares through the ups and downs. Right now, the same share that you bought 2 months ago that may have been worth $100, may now be worth $75. As the market continues to move up over time, the contributions you make today may help lower your cost basis. Dollar Cost Averaging does not guarantee any gain, and investments may lose value, but as a strategy, dollar cost averaging allows the investor to minimize market timing risk. There was a very interesting stat from Bank of America which illustrated the value in staying in the market. They found looking all the way back to 1930, if an investor missed the S&P’s 10 best days in each decade, total returns would be just 91%, instead of a 14,962% return if they stayed in for the duration. That’s a 14,871% difference for being out of the market for just 10 days every decade! Stopping contributions when the markets are down may seem like you are putting a stop to the hurting, but in turn, you are not buying when investments are at their lowest. Market turbulence can be scary, but for investors with a moderate tolerance for risk, and a time horizon of 10 or more years, right now the best thing an investor can do is to follow their plan and stay the course.
- Dollar Cost Averaging https://www.investopedia.com/terms/d/dollarcostaveraging.asp
- Stock Market Losses https://www.usatoday.com/story/money/2020/03/21/stock-market-collapse-how-does-todays-compare-others/2890885001/
- Dollar Cost Averaging Story https://www.businessinsider.com/dollar-cost-averaging-into-a-stock-crash-2014-9
- S&P500 Top 10 days https://www.cnbc.com/2020/03/07/when-you-sell-during-a-panic-you-may-miss-the-markets-best-days.html
- Yahoo Dow Jones https://finance.yahoo.com/quote/%5EDJI/
- Yahoo S&P500 https://finance.yahoo.com/quote/%5EGSPC?p=^GSPC&.tsrc=fin-srch
Stock investing involves risk including loss of principal.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results.
All indices are unmanaged and may not be invested into directly.
The Standard & Poor’s 500 Index is a capitalization weighted index of 500 stocks designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries..