Generally, cyclical trends run for periods of four or five years. During wealth accumulation, you are adding money to your investments on a periodic basis. This is called Dollar–Cost Averaging (DCA). Your average cost of shares will always be less than the average price of the shares, because you will be buying more shares during market troughs for the same dollar amount.
Here is an example of how dollar cost averaging (DCA) can benefit you in accumulation portfolios.
Example 12.1
Brian is planning to add $600 each year to his investment. The share price is $10 right now. The following year, a bear market arrives and the share price drops from $10 to
$7. After hitting that low point, the share price recovers gradually. After a while, it recovers fully and the share price comes back to $10.
The following table shows the activity in the account:
Year Share
The average cost of shares over this time period is $8.80 per share, calculated as ($10 + $7 + $8 + $9 + $10) / 5
Brian’s average cost was $8.63 per share, calculated as $3,000 / 347.38
For the same $600, Brian was able to buy more shares when the price was low.
Therefore, when the share price went back up to $10, he had more shares to participate in the rise. At the end of the cycle, even though the share price was exactly the same as it was at the start of the bear cycle, his total cost was $3,000 and the total market value was $3,474.
Therefore, Brian’s net profit attributable to DCA is 15.8%, calculated as [($3,474 / $3,000)–1] x 100%.
In a distribution portfolio, reverse dollar cost averaging (RDCA) works exactly the opposite of DCA. Investments are sold periodically to provide an income. During a bear market, you must sell more shares at a lower price to maintain the same income stream.
Even though markets may recover subsequently, your loss is permanent. That is because the shares that you already sold are no longer in your portfolio and cannot participate in the recovery.
In Example 12.2, Ed has $5,000 in his portfolio and he withdraws $600 each year from his portfolio.
Example 12.2
Ed has $5,000 in his equity index investment. He is planning to withdraw $600 each year from this investment. The share price moves exactly same way as in the previous example.
For the same $600 periodic income, Ed was forced to sell more shares when the price was low. Therefore, when the share price went back up to $10, he had fewer shares to participate in the rise. At the end of the cycle, his total cost was $2,600 and the total market value is $2,126.
Therefore, Ed’s net loss due to RDCA is 18.1%, calculated as [($2,126 / $2,600)–1] x 100%.
An average retiree can expect to endure between three and five bear markets during his retirement. If income is withdrawn from fluctuating assets such as equities, a significant portion of the portfolio life might be lost due to RDCA during a typical retirement. On average, RDCA can reduce the portfolio life by about 15%.
The way the math works, given the same bear market, the percentage loss from RDCA is always greater than the percentage profit from a DCA. This is because as you add money over time to an accumulation portfolio and as it gets larger, the effect of DCA diminishes.
Table 12.1 shows the profit due to DCA and Table 12.2 shows the loss due to RDCA for different periodic amounts:
Table 12.1: Profit created by dollar cost averaging Periodic Deposit as a
Percentage of
Table 12.2: Loss created by reverse dollar cost averaging Periodic Withdrawal as a
Keep in mind, figures in Tables 12.1 and 12.2 apply only to Example 12.2. A bear market with a different price pattern will produce different results. In any case, the percentage loss from RDCA is always higher than the percentage profit from a DCA for the same percentage money flow.
Example 12.3 demonstrates the effect of RDCA during a sideways market when withdrawals are monthly.
Example 12.3
Bob II has $1,000,000 in his retirement portfolio. His investment consists of the DJIA equity index. He is planning to withdraw $5,000 each month ($60,000 annual). We want to isolate the effect of inflation in this example, so we keep withdrawals constant over time.
Bob II retires on January 1st, 1966. The starting value of the DJIA then is 969.26. We calculate the portfolio value over time. Bob runs out of money after 177 months (14.75 years), in September 1980. At that time the index is 939.42. Plugging these numbers into a standard financial calculator and entering PV=–969.26, FV=939.42, n=14.75, we calculate the compound annual return as –0.212% during that time period.
Now, we calculate how much a portfolio would have lasted without any fluctuations using this calculated growth rate of –0.212%. We find out that it lasts 196 months. This is how long the portfolio would have lasted if there were no fluctuations to create reverse dollar cost averaging.
Bob II’s portfolio would have lasted about 11% longer if there were no fluctuations to create the RDCA effect.
For depleting portfolios, the effect of RDCA becomes less pronounced as time goes on.
In the example above (Example 12.3), during the final five years, the actual portfolio asset value declined steadily, parallel to the non–fluctuating line. This is because at this stage, withdrawals create a much larger decline than market fluctuations. This implies that for depleting portfolios, the RDCA is generally more damaging in the early years of retirement, just like the sequence of returns.
Conclusion:
Cyclical trends create reverse dollar cost averaging. This can shorten portfolio life. The following strategies will minimize the adverse effect of RDCA:
• Include cash or money market funds in your holdings. Periodic withdrawals should come only from the cash balance or money market funds. Do not withdraw from any fluctuating investment. (see also Optimum Asset Allocation – Chapter 16)
• Frequent rebalancing can cause significant damage to your distribution portfolio.
Make sure to optimize rebalancing frequency (Chapter 6).
Be aware that these measures can help only to mitigate the effect of RDCA. They do nothing for the luck factor.
Many people think that by allocating a large portion of the portfolio to cash or cash–like
“buckets” they can also remove the effect of the sequence of returns. This is not so. The other two components of the luck factor, i.e. the sequence of returns and inflation, are minimized only by exporting the risk. Holding large amounts of cash in a buy–and–hold portfolio will allow you to sleep better, but the portfolio will likely run out of money sooner.