One of the most basic tenets when you are saving for retirement is to dollar cost average your investments by contributing the same amount of money each month (or quarterly or weekly, depending on your preferred investment schedule). By doing so, you’ll end up purchasing more shares of the (usually) mutual funds when the price is lower, and fewer when the price is high. The end result is that you end up purchasing more shares at a lower average cost, than by purchasing the same number of shares each month. For an example, let’s check out the following table:
Dollar Cost Averaging in Action
If you wanted to invest $100 in the Vanguard 500 index fund (the first and probably most popular index fund) on the fifteenth of each month (or the last business day before the fifteenth, for months when the fifteenth falls on a weekend or other holiday), this shows you an example of how dollar cost averaging will lower your expenses. If you take a straight average of the share price, you come up with a share price average of $87.56.
But, you didn’t purchase the same number of shares each month, did you? Nope, because you put in the same amount of money each month, you ended up buying a total of 13.913 shares; dividing the total you spent ($1200) by this number of shares, and you’ll see that you bought your shares for an average price of $86.25. Because of your dollar cost averaging, your per share cost is a bit lower than the average share cost of the year. If you’re in the process of buying sharing to build up your investments, this is a good thing; more shares for less money!
But let’s reverse the money flow; imagine you’re a retiree who is selling your investments in order to generate additional funds in retirement. Now, you are selling enough shares of your Vanguard 500 index fund to generate $100 each month. You’ll have to sell more shares when the price is low, and fewer when the price is high. The end result is that you’ll get less money for selling more shares; not the sort of situation in which you want to find yourself.
This is known as negative dollar cost averaging (DCA); where the process of dollar cost averaging, when thrown into reverse, ends up increasing the number of shares you need to sell in order to keep your cash flow the same. (It was mentioned as part of Yes, You Can Still Retire Comfortably!, which recommended a version of market timing to counter the problem.) How can you prevent negative DCA from taking its toll on your investments? There are a few possible methods:
1) Sell a constant number of shares: Negative DCA results when you sell different numbers of shares at different prices in order to generate constant cash flow. You can break up this problem by selling a constant number of shares instead. If you sell one share each month (for our example), you know that by the end of the year, you’ll have sold 12 shares, regardless of the changing share price over the year. The problem is, you’ll have to accept a fluctuating income stream from your sales; if the share prices drop in half, your income from selling these shares drops in half, as well.
2) Rebalance your portfolio regularly: Assuming you have more than one type of investment in your portfolio (and you should, unless you have a target-date fund, which will rebalance automatically), you should make an effort to rebalance your portfolio on a regular basis. (At least yearly, although quarterly or even monthly rebalancing can work provided you are working in a retirement account and don’t have to worry about taxable events when buying and selling mutual funds.)
When you rebalance, you sell the portion of your portfolio that has risen above your desired allocation and use the proceeds to buy the under-performing funds. You’ll be putting the ‘buy low, sell high’ formula back to work for you, and won’t have to worry about negative DCA working against your progress. Alternatively, you could…
3) Sell from the best performing funds: A poor (or tax-adverse) man’s version of rebalancing, you can sell from the funds that are performing the best (the ones that represent a larger portion of your portfolio than you originally intended). The result is that you’ll bring your portfolio more into line with your desired portfolio, and you’ll avoid having quite so many taxable events (since you won’t be selling large portions of your portfolio to shift them around at once). While not completely relieving the need for occasionally rebalancing your portfolio when things get really off kilter, it’s not a bad way to generate needed funds without causing any negative DCA problems.
Hopefully, you now have a better idea about negative DCA, and what it will do when you start to draw down your retirement income.
Has anyone else given any thought to negative dollar cost averaging (or dollar cost averaging in general, for that matter)? Are there any other methods of avoiding negative dollar cost averaging that I missed? Aren’t mathematics just a load of fun?
Related Websites
Hank
on April 9 2010
You are splitting hairs here. You praise dollar cost averaging when it is helping you buy shares at a lower cost basis but also knocking it when it does you more shares when selling. Negative dollar cost averaging will average itself out going both ways, when you buy and when you sell. You will have to sell more shares each month like you said in a rising market. Retirees should be more focused on withdrawing their nest egg at a constant percentage such as 3% to 4% in order not to outlive their money.
Hank´s last blog ..Do Not Watch Your Bankroll Or The Stock Market Either
Roger
on May 14 2010
@Hank: Very true; in the grand scheme of things, attempting to avoid negative dollar cost averaging as a result of the normal, fairly minor price fluctuations when you’re selling will have little impact on the final amount of money you are able to withdraw. Much more important is setting up a reasonable withdraw rate and strategy to ensure (as much as possible) that your money survives longer than you. Still, any technique that can add even a little bit of money (and therefore time) to your retirement pot should be considered.