In a previous article, I mentioned two principles; the “Rule of 72” and dollar cost averaging. The Rule of 72 is utilized by dividing your percentage rate of return by 72, which determines how many years it will take for your money to double. Dollar cost averaging is a principle that helps you take advantage of managing risk and purchasing more assets over time, while taking advantage of the markets ups and downs. Today I would like to expand on that principle by talking about power contributions.
I am not the inventor of this concept. I learned it from one of my mentors, who in turn learned it from Warren Buffet. It utilizes the power of dollar cost averaging with a twist. However, in order for this to be effective, you must have some knowledge of spotting market down turns and market up swings. It is important to note that you don’t need to be able to “time” the market’s absolute bottom and absolute top. You just need to know how to recognize when the market has switched gears.
The Stock Market will only do three things, it will go up, it will go down, and it will go sideways. Over the course of this material, we will give you the tools and resources to be able to take advantage of those three principles and also how to spot market trends.
The traditional suggested method of investing in your retirement account or 401k is to invest a fixed dollar amount each month. Depending on how your 401k invests and the equities it invests in, your money will grow quicker than if you merely invested one lump sum at the beginning or end of the year. For example, let’s say you determined that you want to invest 5% of your annual income into your 401k. Let’s say that number is $12,000. You have two options: invest the entire lump sum at once or spread it out over the course of the year. Most of our 401k’s are designed to be spread over 12 months, but it may not be the only option. For our example, let’s assume your 401K is invested in growth stocks. Based on that, hypothetically, let’s say that the stock price of that equity or basket of equities is trading at $50/share. Based on your investment capital, you can buy 20 shares this month ($1,000÷$50=20). Like all stocks, this price is going to fluctuate each day and month, but for the purposes of this illustration, we will assume the price fluctuates over the course of a year.
| Month | Share Price | Total Shares |
| January | $50 | 20 |
| February | $45 | 22.22 |
| March | $45 | 22.22 |
| April | $40 | 25 |
| May | $40 | 25 |
| June | $35 | 28.57 |
| July | $30 | 33.33 |
| August | $25 | 40 |
| September | $20 | 50 |
| October | $15 | 66.66 |
| November | $12 | 83.33 |
| December | $12 | 83.33 |
| Total | $12,000 | 499.66 |
Based on the table above, you invested $1,000 every month accumulating 499.66 shares. If you had waited to purchase the shares in a lump sum in January, you would have only been able to purchase 240 shares. So you can see the power of dollar cost averaging.
Some of you may have picked up the flaw with this theory, what if I bought all my shares in January, which would have given me 1,000 shares. That would be great, but you would have needed a crystal ball to know this. There is a better way where you don’t have to time the market perfectly to be able to anticipate much better results. This is where power contributions come in. In my example, the share lost over 50% of their value in a year. This is typical during a market crash. Don’t be conned into believing we won’t have another crash. If you do your research, we have Bear Markets that lose a minimum of 20% all the time, so it’s not a matter of “if”. It’s a matter of when.
Market Direction
You’re probably asking the same question I had when I was first taught this concept. “How do I spot a Bear Market?” The strategy I use is “technical analysis”. There are many ways to analyze this information. Investor Business Daily is a good resource to check out for more on technical analysis. You don’t have to subscribe to a service or buy a course to learn the basics of technical analysis, but it’s certainly an easier route to go in many cases. I would encourage to do some research on a solution that works for you.
The table below shows the power contributions formula in action based on a market crash. This is a hypothetical example, but it is based on real data that has happened in the past. The difference between the two tables is that when the market begins to crash, you invest a portion of your 401k contributions in cash or a cash equivalent (Consult your 401k manager for this information) and minimize your investment in the aggressive growth stocks. In my example, I invested only $100 into the stock and the rest in cash. Once the market begins to recover, you transfer all that cash into your aggressive growth fund. Here’s how it looks.
| Month | Share Price | Total Shares |
| January | $50 | 20 |
| February | $45 | 22.22 |
| March | $45 | 22.22 |
| April | $40 | 2.5 |
| May | $40 | 2.5 |
| June | $35 | 2.86 |
| July | $30 | 3.33 |
| August | $25 | 4 |
| September | $20 | 5 |
| October | $15 | 6.66 |
| November | $12 | 8.33 |
| December | $12 | 600.00 |
| Total | $12,000 | 699.62 |
As you can see, in our example we increased our share quantity by 200 shares. Based on an assumption that the price will recover back to $50 a share, the difference in invested money between the two samples is $10,000 (499.66x$50=$24,983 / 699.63x$50=$34,981).
Important Takeaways
Although my example is hypothetical, you can actually go back in time and try back testing some of this stuff. My 401k allows me to pull history prices, so I am able to look at the size of my account at those times and apply these principles. Based on my personal 401k, if I had known this principle at the time and applied it, my account value would be over 3 times the amount it is today.
Also, in the typical dollar cost averaging method, you actually lose out even more because of the negative returns your fund will show. Any negative return on the year requires a positive return greater to the negative return to get back to break even. This doesn’t typically happen in a week or month, but rather in years. History of the market always shows that a crash is far more severe over a short period of time and a trend up to original levels takes years. The crash of 2008 shows the market go from 13,000 points in May to a low of just over 7,000 points the following May of 2009. It didn’t return to its original level until March of 2013. If you were like me, your account value lost over 40% in just one year and took 4 years just to get back to break even. Money is not the problem, time is. This formula won’t be exact, and I can’t guarantee absolute success, but I can honestly say that you will be in much better shape than the alternative of putting your 401k on cruise control.
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