There is a very common investment strategy promoted by stock brokers, mutual fund sales people, investment brokerage firms, financial planners, mutual fund companies, and insurance companies that sell variable annuities: Dollar Cost Averaging.
The concept is simple: Invest the same amount each month during the accumulation phase. When prices are high, the investor buys fewer shares. When prices are low, the investor buys more shares. Over time, assuming the market grows over the long term, and assuming the investor retires at a market high, the average share price might be lower than if the investor tried to time the market and invest 100% of their money all at once.
This strategy is not a guarantee of positive results, although virtually every piece of sales literature always shows this strategy to be effective.
There is another side to this particular coin, another edge to the sword, if you will:
Reverse Dollar Cost Averaging
What happens: when an investor is selling shares of mutual funds, stocks, bonds, or variable annuity units, in order to produce retirement income, they are selling fewer shares when prices are high, and more shares when prices are low, in order to produce steady income (just like what is required under Internal Revenue Code Section 72 in order to avoid the 10% penalty tax).
Reverse Dollar Cost Averaging can produce the opposite effect as Dollar Cost Averaging, and increase the risk to a portfolio running out of money before the investor’s needs run out (i.e., death), especially during a bear market at the wrong time.
If an investor is taking distributions which are part of a series of substantially equal periodic payments from an Individual Retirement Account (IRA), or non-qualified deferred variable annuity, and the underlying portfolio is made up of non-guaranteed risky assets, like stocks, bonds, real estate, precious metals, or mutual funds that invest in these risky assets, then Reverse Dollar Cost Averaging does not reduce risk - it actually increases risk!
There are solutions to the risk inherent with Reverse Dollar Cost Averaging:
- An Income Annuity - Single Premium Immediate Annuity, or SPIA.
- A Fixed Annuity
- An Index Annuity