What is Reverse Dollar Cost Averaging?
I have to admit, I was a bit baffled when I heard the term "reverse dollar cost averaging". What in the world does that even mean? I could think of a few things but I wasn't sure so I had to do some research.
Turns out the opposite of dollar cost averaging is simply people skewing semantics. It could just as easily be called "averaging out" in much the same what that dollar cost averaging is often called "averaging
Of course, there will always be proponents of dollar cost averaging (DCA) and critics. It's not a process that has to be right for everyone - it's simply one of many ways to do things.
But, before we get too lost let me explain DCA and reverse DCA.
Understanding DCA and Reverse DCA
What is DCA?
Most of you already understand dollar cost averaging. In essence, it boils down to these two things:
- Use a scheduled recurring purchase to buy a fixed dollar amount of an asset
- Continue this process regardless of market movements
It's really that simple.
Advantages of DCA strategies include automation, smoothing out the impacts of market price swings on your portfolio, and avoiding buying at the absolute top or bottom. There's no need to time the market.
Disadvantages of this method are that you will never see as good of a return as someone who manages to time the market. Most investors, particularly casual investors like you and I, don't have the skills to time the market anyways. Besides, tons of data shows that it's likely impossible to statistically time the market anyways.
What is Reverse DCA?
Reverse DCA or dollar cost averaging sell side is the same concept, applied to selling your portfolio.
We all spend lots of time thinking about how and when to buy securities. However, few of us pay attention to thinking about how we will manage the sell side operations in retirement or in the future.
In much the same way that we don't want to buy securities "high", we also don't want to sell them "low".
Reverse dollar cost averaging is simply the process of selling a fixed dollar amount of your portfolio every week, month, or year in retirement (or whenever you're ready).
This runs what could be considered more risk that dollar cost averaging buy side.
Risks of Reverse Dollar Cost Averaging
One of the biggest risks of reverse DCA is getting gaffled by insurance companies trying to sell you lifetime income in the form of annuities.
Now, don't take this the wrong way. Annuities are not inherently evil. In fact, they belong in most people's retirement portfolios. However, they're much more complex and difficult to master than 99% of retirees understand.
Before I talk about the dangers of reverse dollar cost averaging, just know that insurance companies and annuity salesmen will use these same concepts to scare you into annuities that aren't right for you. There are more ways to combat the dangers of reverse DCA than most annuity salesmen would like you to know about.
The biggest risk is that selling shares in a down market early during retirement has a massive negative impact on your portfolio.
Putting your portfolio on "auto sell" can be really dangerous. I'm going to put the links to two studies that provide some background information here (study 1) (study 2). These T Rowe Price and Vanguard studies both take a look at the impact of retiring into a bear market (down market).
Because most retirees need to sell their investments to generate income in retirement, a downturned market early in retirement (most critically in the first 5 years according to T Rowe Price) is very dangerous. Because of this, retirement nest eggs could be depleted before you had planned!
Solutions to Reverse Dollar Cost Averaging Issues
I will most likely address this topic in much greater detail in the future during a course or more in-depth article. However, let's take a look at a common solution to the problem of reverse DCA when faced with a bear market.
The issue with selling on a schedule arises when you are faced with selling into a bear market. To solve that problem, you'd need a way to get the income you're looking for without having to touch your investments.
Well, that's easy! Instead of selling investments to make the income you could:
- Keep working longer than you planned
- Live off a bank account savings if you have one
- Withdraw funds from a cash value life insurance product
- Use a system of annuities to provide the cash you need no matter what the market does
- Create a stream of passive income before you retire
- Use yield-focused investments that are highly defensive
- Reverse mortgage your house
- Reduce spending
Note: I am not specifically recommending any one of these in particular above others.
Any of these, or a combination of more than one, can create the cash you need to keep living without selling investments. Then, once the market recovers, you just keep on selling your investments happily!
Of course, the real issue here is determining which one of these solutions is best for you. Unfortunately, I can't do that for you. At least not without a lot more information!
Problem: Reverse dollar cost averaging causes you to blindly sell into bear markets. Blindly selling into bear markets early during retirement can lead to a destroyed portfolio.
Solution: Find a way to get the income you need to live during retirement with additional assets that aren't exposed to the market.
There's some heady stuff in here but I tried to keep it down to a conversational level. Leave me a comment if you have questions or need anything clarified.
Reverse dollar cost averaging it turns out is simply selling on a schedule. Quite honestly it's just as appropriate to call it "averaging out". The concept itself is not bad or evil.
However, like almost everything in investing, you have to understand its inherent pros and cons. Applying the right strategies and approaches to the appropriate situations is the difference between ignorance and happy retirement.