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
$60.80
23.21
Thanks to those dividends, that same $2,000 is now worth $2,320.90 -- in spite of the fact that the index wound up exactly where it started.
Now's a great time to start
The combination of dollar-cost averaging and dividend reinvestment will earn you a better return in the real world than simply buying and holding -- and that's especially true in a market as volatile as this one.
Thanks to the recent market meltdown, many stocks are trading substantially below their 52-week highs -- meaning you can snap up more shares for the same investment.
Company
Recent Price
52-Week High
Industry
Goodyear (NYSE: GT)
$16.98
$36.67
Rubber & Plastics
Terex (NYSE: TEX)
$43.59
$96.94
Farm & Construction Machinery
Allstate (NYSE: ALL)
$44.15
$61.22
Property & Casualty Insurance
Valero (NYSE: VLO)
$32.63
$78.09
Oil & Gas Refining & Marketing
Wyndham Worldwide (NYSE: WYN)
$15.75
$38.73
Lodging
WellPoint (NYSE: WLP)
$44.87
$90.00
Health-Care Plans
Macy's (NYSE: M)
$15.58
$45.50
Department Stores
Data from Yahoo! Finance.
If you're not already dollar-cost averaging and reinvesting your dividends, this is the time to start.
Foolish final thoughts
The market may have been flat over the past 10 years, but the difference between a 0.63% rate of return and a 2.29% rate of return is significant -- especially in your retirement portfolio, where it will compound with all of the rates of return to come.
At Motley Fool Rule Your Retirement, we urge subscribers to make full use of the power of dollar-cost averaging and dividend reinvestment. In times like these, they are key strategies for securing a better long-term future. |