Makin' Money

Dollar Cost Averaging–Revisited

Chris Farrell May 25, 2011

A nice savings tool for long-term investors is dollar cost averaging. Technically, dollar cost averaging means putting the same amount of money into an investment on a regular basis over a long period of time. Let’s say you are putting $100 a month into a retirement savings plan or a college fund. When the market is up, you can buy only 10 shares. When the market is down you can buy 20 shares.

The real benefit of dollar-cost averaging is that it takes emotion –fear, greed, and panic out of investing. You don’t try to time the market, either at the top or at the bottom. You’re automatically dollar cost averaging in retirement savings plans like 401(k) s and 403(b) s, since a portion of your paycheck is regularly invested in the markets. The Wall Street Journal columnist Brett Arends has a savvy column on dollar cost averaging by looking at the experience of the technique during the Great Depression.

Market volatility is the long-term investor’s friend with dollar cost averaging when we’re accumulating assets.

But it’s a toxic technique when you’re withdrawing money from a retirement savings plan.

But it’s a toxic technique when you’re withdrawing money from a retirement savings plan. I hadn’t thought about it before attending the Life-Cycle & Saving conference at Boston University. A major theme of the conference were the deep and troubling difficulties associated with taking money out of a 401(k) plan during retirement.

I had a hallway conversation with David Babbel, Professor Emeritus of Insurance and Risk Management at Wharton.

Now let’s say you about to retire. You want your money to last 30 years. How about a “reverse” dollar cost averaging practice? Bad idea. Babbel said that if someone did a “reverse” dollar cost averaging technique with their stock portfolio ($&P 500) they’d have a more than 90% chance of running out of money before the three decades was over. Ouch.

Dollar cost averaging while accumulating assets, good.
Reverse dollar cost averaging while drawing down assets, bad.

It’s one of many reasons to be wary of rules of thumb, such as the well-known one that you can withdraw 4%-plus inflation from your retirement savings plan every year.

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