The Risk of Reverse Dollar-Cost Averaging for Retirees
After a lifetime of working, retirement is a time that we should be able to relax and enjoy ourselves. Unfortunately, retirement is stressful for many people simply because of the financial implications of living on a limited budget and keeping a close eye on dwindling savings. One common mistake that many retirees make is reverse dollar-cost averaging. While dollar-cost averaging itself is considered a tried-and-true method of smart investing, doing the reverse can be detrimental to your retirement savings.
What exactly is dollar-cost averaging? And how can reverse dollar-cost averaging be risky to those who live on a fixed income? Here’s what you need to know.
Explaining Dollar-Cost Averaging
Dollar-cost averaging is a method of investment that many people use to cut down on risk and increase returns. If you invest in shares with a lump sum of money and the price per share later drops, so will the value of your investment. Dollar-cost averaging protects against this loss by dividing your lump sum into equal investments over a period of time.
For instance, instead of investing $12,000 all at once, to take advantage of dollar-cost averaging you would invest $1,000 every month for 12 months no matter the share price. Share prices will always fluctuate, but by investing with this method, you’ll take advantage of the average price over the duration of the year instead of the share price at one moment in time. It won’t always increase over the course of a year, but the average share price year over year is less volatile than it is month to month.
When you’re working and collecting a steady income, dollar-cost averaging may be a great idea. This is the accumulation phase of your life. It’s the right time to work hard and invest as much as you can to get returns that you can take advantage of during retirement.
Reverse Dollar-Cost Averaging
Reverse dollar-cost averaging is the opposite of dollar-cost averaging—taking the same amount of money out of investments at regular intervals. For retirees, you’ll likely need to withdraw from investments regularly to cover monthly expenses. But while you’re taking out the same amount every month, you’re selling a different amount of shares depending on the share cost at that specific time. This means you’ll lose money if share prices are down.
You won’t necessarily see loss from reverse dollar-cost averaging until later. If the market trends down over the period of time that you’re withdrawing money on a regular schedule, your investments will be worth less, meaning withdrawals will cost you more. It’s already considered a smart investment practice to pull money during upturns in the market and keep it in investments during downturns. But if you’re depending on those investments for your monthly income, you may not have the flexibility to choose when to pull money out.
The Key to Pursuing a Healthy Retirement
You’ve saved up and invested for retirement for many years during your career. But managing money changes when you no longer have a steady income from a full-time job. The key to keeping your money safe during retirement is controlled depletion. You will need to pull money from investments—either on a regular basis or periodically, depending on your circumstances. It’s important to mitigate risk so your retirement funds are more likely to last through the rest of your lifetime.
You can’t always depend on the volatile stock market to keep your money safe, so it’s important to diversify retirement funds. If you need to pull income from investments every month, it’s best to pull from those that are lower-risk, like bonds or even high-yield savings accounts. The rate of return on these investments is typically more consistent. So while you may not earn as much money, you won’t lose as much money if you need to take funds out while the market is down. You should wait until the market is up to take out high-risk investments, like stocks.
If you’re worried about managing your money during retirement, reach out to a financial professional for help.
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