Wednesday, February 20, 2013

Benefits of Dollar-Cost Averaging: Part II

Last month I introduced the concept of Dollar-Cost averaging with just a simple example. You can see that distributing your contributions to any sort of retirement fund will have the effect of averaging your purchasing power (and essentially your risk) over the course of time.  By making smaller monthly contributions as opposed to a once a year bigger contribution, you can take advantage of buying more share when the price is low, and less shares when the price is high.  Giving into this theory is also a humbling experience in that you are admitting that you cannot possibly know when the market will be ripe for the purchasing.

I took this example to the next step and applied a real world and "more true" example.  I did a thought experiment in which someone were to invest an inflation adjusted amount in the S&P on a monthly basis over the course of 26 years (this ended up being the data I found and was easily available).  What would their portfolio look like?  I first looked at the month end  values of the S&P going from December 2012 all the way back to 1986.  I then used the Consumer Price Index (CPI) to invest a monthly contribution of $230 in today's money.  You can do the math as to what portion of your gross income $230/month is.  It just seemed like a low enough amount to be plausible  and a high enough amount to make it worth while.  I should also note that these contributions are contingent on very low to zero commissions as found in a 401k or IRA.  The $230/month also worked out to be the value of the CPI in December 2012.  After doing the math, you can see my returns as the blue line in the graph below:
If the information looks a little small, I apologize, but the gist of it all is that an inflation adjusted contribution to an S&P pegged index fund (ignoring expense ratios) will net you a portfolio value of $109,660 over the course of 26 years.  Total dollar contributions ended up being $54,335.

The red line which correlates to the secondary axis is a calculation I did each month which determines the dollar cost average of the stock each month.  At the end of December 2012, the S&P was pegged at $1,426.19 whereas our portfolio dollar-cost averaged value was $1,037.42 which means we had capital gains of about 37% over the time span.  

The lesson learned here is that a simple index fund can really pay off over time.  Even during the dips and booms, buying an index fund as a proportion of your portfolio through a dollar-cost averaging process can really pay off.  You just need the discipline to pull this off, and you should find yourself ready for retirement.

Wonderful Moment of the Day: Coming home to a meal ready and prepared by my Wife...awesome!

No comments:

Post a Comment