Beat the market - by doing nothing

NEW YORK (Money) -- With the stock market back near highs after a particularly rough summer, it would be nice to think that gut-wrenching turbulence is behind us.

But who are we kidding?

Money Magazine senior writer Janice Revell

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With dreary news coming out of the banking and real estate scenes almost daily, and the dreaded "r" word (as in recession) getting tossed around, roller-coaster madness is the new normal in the stock market.

It's a scary situation. But it doesn't have to wreck your retirement.

The single most important thing you can do in a turbulent market is stick to your 401(k) game plan - that means contributing regularly and definitely not panicking and selling.

In fact, if you had stayed the course when the stock market was tanking in July and August, you actually would have made a far better return on your money than if the stock market had stayed flat - or even increased modestly.

The reason comes down to dollar-cost averaging. Let's say, for example, that you contribute $500 from your paycheck every two weeks to your 401(k). Of that amount, let's further assume that you are allocating 80%, or $400, to a low-cost stock fund, such as Vanguard's S&P 500 index fund.

Looking back at the third quarter, you would have made seven contributions (assuming you get paid every other Thursday). Each $400 allocation to the index fund would have purchased a different number of shares. (see table)

On July 19, for instance, when the fund was trading at $143 per share, you would have bought 2.8 shares. On Aug. 16, when the price had tanked to $130, you would have picked up 3.1 shares. All told, by the end of the quarter you would have purchased 20.46 shares for a total cost of $2,800.

How did the market overall do during that time? By the end of September, it had just barely recovered from the 10% plunge it took in July and August, when the credit crisis was in full swing. As a result, the Vanguard S&P 500 index fund managed to eke out a gain of just 0.8% for the third quarter.

But you would have done much, much better. On Sept. 27, the 20.46 shares you purchased were worth $141 each, for a total of $2,885. That translates into a 3% gain on your 401(k) contributions for the third quarter - a return that most professional money managers would have killed for.

And you would have gotten it because you had the courage to keep buying as the market fell.

By the way, you would had gotten the same type of great returns if you had been buying stocks right after the Crash of 1987 - or after any other big drop. As long as your investing timeframe is long enough to allow the market to climb back from a potentially severe plunge - about 7-10 years - then you will usually be far better off contributing to your 401(k).

That's not to suggest that dollar-cost averaging alone is a panacea for anything that might ail your 401(k). If we get another prolonged bear market and you don't have a lot of time on your side (if you're planning to retire in 5 years' time, for instance), your stock investments are going to take a hit no matter what.

So to be truly shock-resistant, your 401(k) must hold a diversified mix of stocks and bonds. And you have to rebalance every year. I'll get into those issues in future columns.

In the meantime, just remember that if you have a decent time horizon and you're diversified, your best bet in a volatile market is to simply let your 401(k) do its thing. Resist the urge to mess with it. You won't regret it.

Questions or comments about retirement? Send e-mails to jrevell@moneymail.com.