Dollar-Cost Averaging Works Well for Retirement Contributions

Sometimes it’s just not worth trying to get fancy. Such is the case with retirement contributions. If you’re making regular contributions to your retirement plan savings every pay period or every month, invest the money as soon as it hits your retirement savings account (aka dollar-cost averaging). Don’t worry whether the market is up or down; put the money to work. Doing so has good odds of being the most profitable step you can take.

As a thought experiment, I crunched the numbers on adjusting the timing and size of contributions based on the calendar or market performance. In all cases, the simplest strategy of investing the contributions each and every month stood out as being highly effective. Even when returns were higher from a timing strategy, the difference in wealth was not great enough to offset the risk of making a mistake by trying to fancy things up.

Before I get into describing the analysis and the findings, I want to address one big thing: as your retirement portfolio grows in size, the impact your contributions will have on your overall savings decreases. For a person with small savings, contributions have a large percentage impact. At larger portfolio sizes, monthly contributions have a small percentage impact. Thus, at larger portfolio sizes, any additional return realized by perfectly timing when contributions are invested will be more than offset by the swings in the overall balance of your retirement portfolio. Nevertheless, you should continue to contribute as much as is reasonably possible since doing so increases the size of your retirement nest egg.

My baseline for this analysis involved monthly contributions made to a portfolio solely holding the SPDR S&P 500 ETF Trust (SPY). This exchange-traded fund (ETF) tracks the performance of the S&P 500 index. I specifically chose this ETF because it’s a good proxy for the performance of the stock market and more than 25 years of monthly data was easily obtainable through Yahoo Finance. I assumed a starting maximum contribution to an individual retirement account (IRA) of $3,000 in 1994 and increased the amount every year relative to the rate of annual inflation. The maximum contribution amounts are not exact for any single year, but the ending limit of $5,063 in 2018 was close enough to the Internal Revenue Service’s cap on IRA contributions for purposes of this analysis. Adjusting the annual (and thereby monthly) contribution amounts to match the maximum amount an investor could have actually put into an IRA each year—exclusive of any catch-up contributions—would not have impacted the findings.

The calendar strategy involved postponing investing monthly contributions at the end of July and at the end of August. This would have avoided investing new dollars at the start of what have historically been the two worst calendar months of the year (August and September). At the end of September, a dollar amount equal to the contributions scheduled to be made at the end of July, August and September were invested. Doing this resulted in virtually no difference in ending wealth relative to simply investing the same amount each and every month. It also showed no consistent advantage in terms of the number of years the timing strategy outperformed.

The timing strategy involved accelerating the timing of contributions to take advantage of market dips. I based it on the data from Sam Stovall that suggests buying stocks when the market falls at 7% intervals can be an effective strategy. Whenever the SPDR S&P 500 ETF fell by 7% or more from its last end-of-month all-time high, monthly contributions were doubled. Then if the ETF fell by 14%, contributions were tripled. If the ETF fell by 21%, contributions were quadrupled.

I’ll use 2008 as an example to explain how this worked. In January 2008, the SPDR S&P 500 ETF was down approximately 11% from the end of October 2007, so the monthly contribution was doubled. The timing formula was then reset to contribute the equivalent of three months’ worth of contributions if the ETF declined by 14% from its high. This rule wasn’t triggered in February, so no contribution was made. In March, the ETF was down 14.7%, so three months of contributions were made. The timing threshold was then reset to an amount equal to four months of contributions being made if the SPDR S&P 500 ETF fell by 21% or more from its high up to the maximum allowable amount for the year. If this threshold wasn’t met, contributions resumed at their regular interval after the accelerated months were skipped. So, no contributions were made in April or May of 2008 and regularly monthly contributions were made in June, July and August of 2008. The SPDR S&P 500 ETF was down 25% from its high in September 2008, triggering the acceleration of four months’ worth of contributions. Because of the annual cap on contributions, only half of this amount could be added and invested. No other contributions were made for the remainder of the year. The 21% threshold for accelerating four months of contributions remained in effect until the market fully rebounded from its financial crisis drop.

If this sounds complicated, it’s because there were shifting rules to follow during market downturns. While the strategy worked during some years, it didn’t consistently lead to better returns. A big reason may have been that a person saving for retirement is limited in how much they can put into a retirement account. The ability to get really aggressive with buying during downturns is limited by the contribution limits. At the same time, the assumption that a person would not accelerate the timing of all of their contributions for the year made a difference.

A final test showed this to be true. Simply investing the maximum annual amount allowable near the beginning of a calendar year (e.g., the end of January 2018 for the 2018 tax year) beat timing strategies and even monthly dollar-cost averaging. For many people saving for retirement, this may be too big of a one-time expenditure. Making regular contributions coinciding with when a paycheck is received is often more feasible and easier to adhere to. For the many who fall into this category, there is a strong case to be made for immediately investing those contributions regardless of what the market is doing.