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Reverse Dollar Cost Averaging
(Updated 6/19/08)
Introduction Price volatility acts to the benefit of the investor accumulating his nest egg. However, that same price volatility also acts to the detriment of the investor spending his nest egg. That’s why “dollar cost averaging” is helpful to the saver. But when it comes time to withdraw from the nest egg, “reverse dollar cost averaging” is no help at all. In fact, in can be quite harmful. Retirement Planning There are two parts to investing for retirement. The first part is easy. Save and invest. Any couch potato can do that. A Target Retirement Fund can do that. The second part is the tricky part. You’re retired with your lazy portfolio. Now what? Just spend the money, right? Yes, but if you’re not careful you can run out of money before you die. If you think the first part -- the save and invest part -- was hard, the second part is even harder. You see, there’s this thing called “reverse dollar cost averaging”. What that means is that if you withdraw from a fund when it’s declining, you'll deplete that fund a lot sooner than when it’s rising. So if you have all your eggs in the one basket called a Target Retirement Fund (or all your stocks in the Total Stock Market), there will be some years that when the stocks are down, that Target Retirement Fund will also be down -- though not as much. That’s why I prefer having a choice of funds to withdraw from. By having many different eggs (like a ‘slice and dice’ portfolio) in your basket, the retiree can now take profits from only those eggs that grew. Don’t touch the eggs that shrank until they recover and grow again. So if young investors have this game plan laid out ahead of time, they won’t be caught off guard and have reverse dollar cost averaging deplete their nest egg prematurely. An Example For this example, I will assume that the retiree will live 30 more years and will spend most if not all of his nest egg. During the course of a 30-year investment time frame, it would be reasonable to assume that all stock funds in the portfolio will experience both up and down years. To give an idea of the nature of 1-year returns, let’s look at the 1-year returns of the S&P 500 since 1926.
This chart was created using my Rolling Returns Spreadsheet (xls)
Notice that the sequence of 1-year returns for the S&P 500 was random. However for simplicity sake, I will make the sequence of returns in this example very predictable. There will be 3 funds. Each fund will have 20 up years and 10 down years during a 30-year period. The overall return for each fund over the 30-year period will be identical. Each up year will be +20% and each down year will be -10%. Thus, each fund will have an average annual rate of return of 9% during the full 30-year period. I will further assume that withdrawals will increase each year by 3 percent to take account inflation. I will start figure 1 with the best case scenario. ‘Fund A’ in white background will start with the return sequence up-up-down (+20%, +20%, -10%) and repeat for the full 30-year period. I will arbitrarily start the nest egg at $10,000. You can multiply all numbers by 100 to simulate a million dollar nest egg at the start of retirement. I will find the annual withdrawal amount necessary to deplete the nest egg at year 30. The first annual withdrawal turns out to be $809. In the real world, a safer withdrawal rate will be closer to 4% -- not 8% as shown in this example. Also in the real world, a retiree’s portfolio would not have stock funds exclusively. But I am showing only funds with volatility to demonstrate the effect of reverse dollar cost averaging.
For the next case, ‘Fund B’ in yellow background, I will start the return sequence down-up-up (-10%, +20%, +20%) and repeat for the full 30 year period. You will notice that ‘Fund B’ runs out in year 20. For the last case, ‘Fund C’ in green background, I will start the return sequence with 2 down years (-10%, -10%). Then the sequence will continue up-up-down (+20%, +20%, -10%) and repeat for the full 30 year period. You will notice that ‘Fund C’ runs out in year 15. I hope you see the lesson here. By holding a diversified portfolio at the start of retirement, the negative impact of a losing fund can be offset by other funds having gains. Let’s see an example.
In figure 2, we start with $5,000 in ‘Fund A’ and $5,000 in ‘Fund C’. Then we take equal systematic withdrawals from each fund starting with $405 each (half of $809) and increasing by 3% each year for inflation. You will notice that ‘Fund C’ runs out in year 14. However, ‘Fund A’ still has money. So in the remaining years, funds are withdrawn from ‘Fund A’. At last, ‘Fund A’ runs out of money in year 21. In figure 3, we again start with $5,000 in ‘Fund A’ and $5,000 in ‘Fund C’. This time, we try to avoid reverse dollar cost averaging. Here, we only withdraw when there is a gain in a fund. Or if both funds gain, then we withdraw half from each. You will notice that now ‘Fund C’ lasts 4 more years than in the previous example; but runs out in year 18. For the remaining years, funds are withdrawn from ‘Fund A’; but nevertheless, it runs out in year 26. Still, this was 5 more years than in the previous example in figure 2.
Conclusion Reverse dollar cost averaging can deplete a retiree’s nest egg sooner than necessary. By having a diversified stock portfolio (such as ‘slice and dice’), in any one year some stock funds will likely have gains while other funds may have losses. A diversified stock portfolio will allow the retiree a choice to withdraw profits from just the gaining funds. The losing funds can be left untouched and allowed to recover; the retiree can then be patient and take profits when they do come at some point in the future. |
