Over the past 10 years, the S&P 500 index has been essentially flat. After closing at 1,164.33 on July 10, 1998, it closed at 1,239.49 on July 11, 2008. That's a whopping 6.5% return in a decade, or all of 0.63% annualized.
Of course, it wasn't exactly a straightforward walk in the park. The decade included such market events as:
Considering the roller-coaster ride of volatility you went through to get that 0.63% annual return, it hardly seems like it was worth the trouble.
It wasn't quite that bad
Although the market was essentially flat, your returns didn't have to be. Instead of a 0.63% annualized return, you could have earned a 2.29% rate of return. Instead of winding up with 6.5% more than you started with, you could have wound up with 12.2% more -- all while being invested in an index fund.
How? Two things:
It's still a far cry from the market's historical 10% long-term rates of return, but it illustrates the long-term power of two of the market's most overlooked forces: dollar-cost averaging and dividend reinvestment.
First, invest regularly
Dollar-cost averaging -- making regular investments of the same amount of money in the same stock or index fund -- takes advantage of market volatility to make your money do more work for you.
After all, every time you buy stock, you turn over your cash for shares. The lower the price of those shares, the more of them you get for your money. And when it comes time to tally up your totals, each of those cheap shares counts for just as much as the ones you bought at higher prices.
Let's say you decided to buy $500 worth of an index fund every year:
Date
Cost per Share
Amount Invested
Number of Shares Bought
7/10/2005
$100.00
$500.00
5.00
7/10/2006
$200.00
$500.00
2.50
7/10/2007
$50.00
$500.00
10.00
7/10/2008
$100.00
$500.00
5.00
Total
$88.89
$2,000.00
22.50
The stock wound up exactly where it started, but your $2,000 investment turned into $2,250 -- thanks to the power of those cheaper shares.
Second, invest regularly
Once you add dividend reinvestment to the mix, the picture gets even brighter. If, every year, the stock throws off a $2.00 dividend, the numbers look like this:
Date
Cost per Share
Amount Invested
Amount From Dividends
Number of Shares Bought
7/10/2005
$100.00
$500.00
$0.00
5.00
7/10/2006
$200.00
$500.00
$10.00
2.55
7/10/2007
$50.00
$500.00
$15.10
10.30
7/10/2008
$100.00
$500.00
$35.70
5.36
Total
$86.17
$2,000.00 Continued... |