What Really Makes Your Retirement Accounts Grow
As far as investing goes, 2011 won't be a particularly memorable year. The Standard & Poor's 500 began the year at 1,257 and ended the year at the exact same spot. So if you began the year with $10,000 in your 401(k) and invested it in an index fund that seeks to mimic the performance of the S&P 500, you'd just have $10,000 a year later, right?
Probably not. The value of your portfolio depends on a few factors:
- The increase or decrease in value of your investments. Okay, so that's obvious. In the case of the S&P 500 in 2011, it ended the year where it started.
- Contributions or withdrawals from your accounts. If you're still saving for retirement, you make an investment every time money gets transferred from your paycheck or savings account to your 401(k) or IRA. Each investment has its own purchase price, and thus its own return. During 2011 the S&P 500 increased to 1,363 by the end of April, then dropped to 1,123 by early October, only to then rebound back to 1,257. If you invested in an S&P 500 index fund, some of the purchases you made last spring may be still underwater, but the purchases you made in the fall have so far produced a nice double-digit return.
- The amount of interest and dividends you receive throughout the year and what you do with that money. I've written before about how dividend growth and reinvestment are a powerful — and under-appreciated — way to grow a portfolio; it can produce a decent return even if the price of a stock goes nowhere for decades. That's because dividends grow, historically at a rate that exceeds inflation. Not every stock pays a dividend, but most of the big names do. In 2011, of the 500 companies in the S&P 500, 394 companies paid a dividend; 320 increased their dividend, 22 started paying a dividend (they weren't paying one beforehand, or it had been suspended), and only five decreased their dividend. Most investors use those dividends to buy more shares of stocks, which pay more growing dividends, which buy more shares, and so on. The same principle applies if you own bonds or bond funds, though you don't get the same type of growth in the payments.
Investors who survived the “Great Recession”
So even though the S&P 500 went nowhere in 2011, someone who kept investing in the Vanguard 500 or any other similar index fund — both through additional contributions to retirement accounts and dividend reinvestment — saw her net investment grow in value. This presumes, of course, that she stuck with the investment as it dropped almost 20% from April to October.
To take a slightly longer-term look at sticking with an investment, a recent report from Fidelity Investments illustrates the value of summoning courage in the face of a downturn. The company analyzed the returns of investors with Fidelity retirement accounts from the market decline of 2008 to 2009 through June 2011 and found the following:
- Participants who changed their equity allocations to zero between Oct. 1, 2008, and March 31, 2009, and never jumped back into the market saw their accounts grow a measly 2%.
- Investors who sold all their stocks, but got back into the market at any point before June 2011, enjoyed a 25% larger account balance.
- Those who stuck with their asset allocations saw their account balances skyrocket 50%.
The analysis also compared investors who stopped contributing to their 401(k)s with those who kept on savin'. The account balances of the former grew 26%, while those of the latter ballooned 64%.
These are important lessons, since the world seems pretty scary these days. Of course, investing when everyone else is scared is what we're supposed to do. But today's risks — debt problems in Europe, falling home prices, swelling government deficits, increasingly unfunded entitlements, computers accounting for most of the trading volume — are real and unprecedented. Plus, the market isn't priced to provide extraordinary returns. I don't know exactly when, but there will be more years like 2011, even those as bad as 2008. During those times, it will be important to remember the conclusions of that Fidelity study: Stick to your allocation (except for occasional rebalancing), and keep on savin'.