Dear Money Lady,
My financial planner keeps telling me not to change my investments, but I can’t handle the fact that I’ve lost so much money. I always invest and save monthly, but I am worried because I plan to retire soon.
Patricia
Dear Patricia,
I think I would side with your advisor right now since you haven’t really experienced a loss unless you sell. I’m glad to hear you invest regularly in a dollar cost averaging savings plan. Let’s discuss how this works.
In 2009, the stock market went down more than 50% much the same as we experienced in 2020 with the recent COVID pandemic. We all felt there was no guarantee that this would be the bottom but then rejoiced in a high market come-back in 2021. Today, if you are still invested, like Patricia, you are experiencing a continued rollercoaster ride in the equity markets with cyclical trends poised to further damage retirement portfolios a little more before we see an upswing, possibly in Spring 2023.
Most investors are familiar with dollar cost averaging (DCA) which is an accumulation process to invest in a specific manner and a defined framework. With DCA you invest a set dollar amount on a continued periodic basis, for example, at the beginning of every month. Of course, market cycles effect the performance of this accumulation process, however after the last fifty years of studies on this investment style, economists now unanimously agree this method always impacts portfolios positively over long-time horizons. You see, by investing consistently, one can take advantage of market swings when share prices are lower and in turn, purchase fewer shares when the prices are higher. Over the long term, the cost of the shares purchased always works out to less than the average share price.
Here is an example of how dollar cost averaging works. You invest the same amount every week, month, or year regardless of the market conditions. In our example we want to invest $5,000 every year into an index fund. At the end of the five years, we have invested $25,000, however due to dollar cost averaging, we own more units, and the portfolio has grown over time to a value of $28,950 (15.8% increase on investment).
Year 1:
Purchased $5,000 at $10/stock
500 units Portfolio value $5,000
Year 2:
Purchased $5,000 at stock price of $7
714 units Portfolio value $8,498
Year 3:
Purchased $5,000 at stock price of $8 625 units Portfolio value $14,712
Year 4:
Purchased $5,000 at stock price of $9 556 units Portfolio value $21,555
Year 5:
Purchased $5,000 at stock price of $10 500 units Portfolio value $28,950
Total invested: $25,000 and the average cost of this stock over the last 5 years was $8.64
So, now that we know DCA works when accumulating wealth over your working years to retirement – what about doing this in reverse. In a distribution portfolio at retirement, reverse dollar cost averaging or RDCA works when investments are sold to provide a monthly income. This standard practice guarantees a monthly revenue stream for clients especially when there are no additional employment pensions plans other than OAS and CPP/QPP. The problem is, RDCA has the exact opposite effect on your portfolio. The cyclical trends that helped build your portfolio, now can cause severe damage when income is taken out. In fact, if the down turns are deep enough, it can cut your retirement portfolio’s life in half. Let’s look at how this happens.
Using the same example as above but in reverse, the total value of your retirement portfolio is $28,950 with current units = 2,895 and the stock price is $10/unit.
Year 1:
Withdraw $5,000 at stock price of $10 500 units 2,395 remaining units $23,950 Value
Year 2:
Withdraw $5,000 at stock price of $7 714 units 1,681 remaining units $11,767 Value
Year 3:
Withdraw $5,000 at stock price of $8 625 units 1,056 remaining units $8,448 Value
Year 4:
Withdraw $5,000 at stock price of $9 556 units 500 remaining units $4,500 Value
Year 5:
Withdraw $5,000 at stock price of $10 500 units 0 units $0.00 value
Of course, this example is an extreme case to demonstrate the effects of RDCA. In real life, a retiree can expect to endure between three to five downward swings to the equity markets. If income is withdrawn from a fluctuating asset class such as equities, the average retiree can expect to lose between 20% to 48% of their portfolio due to RDCA in a typical retirement time horizon of 25 years. Now before you all run to your banks and convert your investment portfolios to GICs and bonds, remember, I would never leave you with this problem without a solution. There are definite and defined ways to combat this mathematical impact to your hard-earned retirement portfolios; however, you will have to wait until next week’s column to get the answers. See you next week.
Good Luck & Best Wishes,
ATML – Christine Ibbotson
Written by Christine Ibbotson, National Radio Host and Author of 3 finance books plus the Canadian Best-Selling Book “How to Retire Debt Free & Wealthy” www.askthemoneylady.ca or send a question to info@askthemoneylady.ca.
