How the Market Crisis can Help your Retirement

TheWriter blogs over at The Writer’s Coin on all things personal finance and about the craft of writing.

So the markets are in a tailspin. If you have any money invested in the stock market, you’re probably not very happy right now. With all the panic and commotion going on, what can a regular investor do? If you’ve heard the advice to go out and buy more stocks right now because they’re so much “cheaper” than they were earlier in the year (and even last year), then you already know what to do.

The Roth IRA Debate

At the beginning of the year, there some debate online about how and when to fund a Roth IRA. I wrote about it at the end of June, claiming that dollar-cost averaging was the way to go. That means putting in a portion of the Roth IRA limit ($5,000 this year) throughout the whole year. 

But a lot of people thought that the best option was to fund the whole $5,000 right away. The reason? There were a few, but mainly it was to give their money as much time to compound as possible and to just get it all done right away and not have to think about it the rest of the year.

Well, the markets are WAY off their January numbers and it’s one of those rare times I get to look back at something I wrote earlier in the year and go, “I was right.” I just hope karma doesn’t come back to bite me in the butt.

If you put the whole $5,000 in your Roth back in January and invested in index funds (like the S&P 500), you’d have around $4,100 right now, that’s a loss of around 18%. But the worst part about it is that you can’t buy any stocks right now even though they’re “cheaper”! You’ve reached your limit and lost all flexibility. There is nothing you can do.

On the other hand

If you put $1,000 into the market in January, then in April, and then in July, you’d have around $2,641 left, a drop of only 12%. And you’d have the flexibility to put more money ($2,000) in at these lower prices, which would reduce your losses if the market keeps going down.

I know that we’re talking a few hundred dollars and, in the grand scheme of your retirement it’s not “that much.” But for me, my retirement is a big deal and if I can do a little maneuvering here and there to save me a few hundred bucks, that’s great. That’s another couple hundred dollars I can compound for 30-some years, and now we’re talking some serious money (around $25,000 compounded at 8%). And don’t forget that you’d be buying more stock at a lower price.

For those of you that find it more convenient (and you have $5,000 laying around in January) to contribute the whole amount right away, I won’t argue with you. But for those of you out there that like to squeeze every last penny out of important things like retirement accounts and that have the time to send money to your brokerage four or five times a year, dollar-cost averaging is a no-brainer.

A Marathon

Since it’s a retirement account, I know it doesn’t really matter how much money you have in your Roth today – you care about how much money you’ll have when you retire. It’s a marathon, not a race – so what happens over the course of one year shouldn’t be too important. But if you can do a little bit every year to make your overall returns that much better, isn’t that a good thing?

P.S. What if the market is going up, smarty pants? Well, then this whole argument needs to be re-evaluated. Maybe when the market is actually going up I’ll revisit that side of the coin.

Comments

  1. I have to disagree. If your plan is to invest for the long term (e.g. Roth IRA), why would you deliberately keep money on the sideline? Your description of dollar cost averaging by intentionally holding money back is even worse than market timing because you are simply choosing random dates to enter the market. At least market timers attempt to study the market and make entry and exit decisions on evidence and analysis (although that rarely works either).

  2. I think the point TheWriter was trying to drive home is that by dollar cost averaging you are spreading out your risk a bit, rather than testing the depth of the water with both feet. As the market goes down, you buy more shares. As the market goes up, you buy less shares, but since they are more expensive, this makes sense.

    I understand your point about it being a retirement account and being in it for the long haul, but I haven’t run the numbers far enough to decide if $5k in January for forty years comes out better than $5k spread throughout the year for forty years. It would be an interesting thing to try if anyone has the mental energy and can report back here.

  3. I liked dollar cost averaging until I read this:

    http://www.dumblittleman.com/2007/07/cost-of-waiting-to-invest.html

    For those who don’t read it, to sum it up $2000 every year for 20 years was invested every year at 5 different times: as soon as possible in stocks, spread evenly through the year in stocks, the best time possible, the worst time possible, and in t-bonds. The results:

    Perfect timing: $146,000
    Soon as possible: $141,000
    Spread Evenly: $134,000
    Worst timing: $128,000
    T-bills: $61,000

    Basically since the market ‘generally’ goes up, keeping any money out is ‘generally’ bad.

  4. Hindsight is 20-20. There are other studies out there that support MBirchmeier’s comment. In my opinion, calling dollar-cost-averaging a “no-brainer” is a bit careless.

  5. MBirchmeir makes a good point, it’s all about the market “generally going up.” But when the market isn’t going up, trust me, you’re better off dollar-cost averaging throughout the year.

    I mean, if you put $5,000 in January are you going to honestly tell me you’d be better off that having the flexibility to buy more stocks right now?

  6. With all the panic and commotion going on, what can a regular investor do?

    Nothing. Sleep. Ill just wait for the market to become alive.

  7. The concept of DCA is sound, but keeping money on the sideline if you are completely long term is not a good idea. The DCA argument works in hindsight, but if the market went up 20% during that timeframe, you would be way in the negative is missed opportunity. Of course, you wouldn’t look at it this way either as you are “in it for the long-term”!

  8. Kevin is totally right. I think if I could contribute to my Roth IRA for 2009 right now, I would probably drop in the whole $5,500 right away. I’m not saying I knew the market was going to do badly back in January, but I honestly didn’t have $5,000 to throw in and DCA made me feel better about it.

  9. Over 40 years, investing $5,000 every January IS dollar-cost-averaging, isn’t it?

    Here’s the problem for most investors… we don’t HAVE $5k sitting around in January. In order to have it, many of us would need to set money aside throughout the year, which would defeat the point of putting it in as fast as possible. So… instead of setting it aside, we invest throughout the year.

    My wife and I contribute a portion of each paycheck, so we’re making about 26 transactions each year.

  10. If you saved up $5000 (let’s say $1000 per month) in order to invest it every January, you would have been better putting that $1000 per month in the market September through December of the previous year.

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