This is a hypothetical example for illustrative purposes only.
In this era of instant gratification, investors have become increasingly gambler-like in the pursuit of immediate rewards; this is why many people gambled on “meme” stocks like GameStop and AMC Entertainment last year and are now focusing on cryptocurrencies and non-fungible tokens, or NFTs. Investors especially lose patience with traditional investing during market drawdowns, like the one we are currently experiencing.
Unfortunately for many of these modern investors, there simply isn’t an immediate reward for saving for retirement. While a new TV or car can be enjoyed immediately, it can take decades for you to realize any semblance of a reward for your diligent 401(k) contributions. Maybe you don’t view retirement as a purchase in the same lens that you would view a new TV or car, yet that is exactly what you do when you participate in a 401(k) plan; you are investing money today to use as retirement income tomorrow. Thanks to dollar-cost averaging, you can strive to retire on your own terms by simply investing a little bit all the time.
Dollar-cost averaging involves investing a constant dollar amount consistently for an extended period. You may not realize it, but your 401(k) already employs the dollar-cost averaging strategy every pay period. Since the prices of the investments in your 401(k) fluctuate daily, your contributions buy a different number of shares each pay period based on the current price.
Dollar-cost averaging allows people to avoid the two most dangerous emotions of investing: fear and greed. When the stock market is down and investors become fearful, dollar-cost averaging automatically helps to avoid fear by buying a greater amount of shares at these lower prices. On the flip side, when the stock market is soaring and investors become greedy, dollar-cost averaging automatically buys less shares at these potential market peaks. In short, when you dollar-cost average, you avoid investing too much during market peaks and too little in market downturns, like the one we are currently experiencing.
We have included a table that helps to illustrate dollar-cost averaging in action. Note that in this example, even though the stock’s price was lower in December than it was in January, the account still had a positive return for the year due to dollar-cost averaging.
While investors can treat the market like Vegas and gamble away, investing a specific amount of money on a consistent basis into the stocks of quality companies or quality investment options in your 401(k) tends to be a more reliable strategy in the long run. The savings process can take decades, and a small deferral amount today may seem trivial, but dollar-cost averaging mixed with compound interest can help turn decades of small-but-consistent contributions into a significant nest egg at retirement.