In an employee-education meetings with our clients, we often received many questions from employees about whether they should continue to contribute to their 401(k) plans in face of the market volatility.
Our answer was a resounding yes due to a method called Dollar Cost Averaging.
What is Dollar Cost Averaging?
The definition of Dollar Cost Averaging is the process of purchasing a fixed dollar amount of a particular investment regularly, despite the share price.
And how does this benefit my retirement plan?
When you set up your retirement plan, you select how your portfolio will be allocated, as well as the amount you would like to contribute. For example, if you make $40,000 and want to contribute 3% of your salary, you will contribute $1,200/year to your retirement plan. This yearly contribution will be broken down into contributions to match your paycheck. So if you get paid monthly, you are contributing $100/month.
Each month, that $100 will buy shares of the investments you have allocated when you set up your plan. The number of shares that is bought with your $100 will vary from month to month, depending on the share price.
Let’s say you wanted to buy $100 of XYZ shares each month. The amount of shares you are able to buy will depend on the share price. Take a look at how this could vary over three months:
|Price per share||$50||$25||$20|
|Number of shares bought||2||4||5|
|Total number of shares in your portfolio||2||6||11|
|Average price per share||$50||$33.33||$27.27|
After the three months you would have a total of 11 shares. At $20/share, your portfolio would total $220. Because you have contributed $300, you might be experiencing a moment of unease, thinking of an exit strategy. However, let’s look at what happens by June when the share price is back up to $50.
|Price per share||$50||$25||$20||$33||$33||$50|
|Number of shares bought||2||4||5||3||3||2|
|Total number of shares||2||6||11||14||17||19|
|Average price per share||$50||$33.33||$27.27||$28.57||$29.41||$31.58|
By June, you would own 19 shares. At $50/share, your portfolio would now be worth $950, with total contributions totaling $600.
While this is purely a fictional example, and it’s important to note that market highs and lows can extend months at a time, I hope it illustrates how one can benefit when the price is low. When the market and shares are down, you’re essentially able to buy shares on sale, which is beneficial in the long-term.
Consistently buying a fixed amount also protects you from market volatility, as you are able to take advantage when prices are low by buying more shares, and also reap the benefits when prices are high.
Of course, with any investment strategy, you want to make sure your investment portfolio is set up with your risk tolerance, goals and objectives in mind. If you feel like you’re losing sleep due to market volatility, make sure to contact us so we can ensure your retirement portfolio is aligned with your objectives.