Hunters Bay Radio
ASK THE MONEY LADY SEPTEMBER 7 2024 DCAS Vs RDCA
This is the Ask the Money Lady radio show where we answer all your questions about money and Christina Bitson and thank you for joining me today. Today Jennifer is going to read a question we received from another radio listener. Thanks Chris. This question is from Patricia. She wrote, "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. I have always used the dollar cost averaging method because it is easy for me to invest that way and my advisor says I am to do the same when I retire and start withdrawing money. What does that mean?" Thank you Jen. Well, Patricia, I think I would side with your advisor right now since you really haven't experienced a loss unless you sell and you're not retired yet. So don't pull away from your investment strategy. I'm glad to hear you invest regularly in dollar cost averaging. Most advisors encourage this method to save and then you're right, they use the same method to create a retirement income stream. So let's talk about how this works to save and to draw down in retirement. Now most Canadian investors are very familiar with dollar cost averaging, which is an accumulation process to invest in a specific manner in a defined framework. Now with dollar cost averaging, you invest a set dollar amount on a continued periodic basis, so for example, at the beginning of every month. Of course, market cycles affect the performance of this accumulation process, however, after the last 50 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 the share prices are lower and in turn, purchase fewer shares when the prices are higher. So over the long term, the cost of the shares purchased always works out to less than the average share price at any given time. Let me give you an example of how dollar cost averaging works. Let's say you invest the same amount every week, regardless of the market conditions. Maybe that's $96 a week, that works out to a total investment of about $5,000 per year. And let's say you put it into an ETF, large cap, US index fund, just for fun. So for this example, to make it easy, we'll assume that during the first year, the stock was around $10. So that's easy math, right? It would give you 500 units, 5,000 invested times 10 gives you 500 units. Now the next year, let's say the stock goes down and the average cost is $7, investing the same amount that 5,000 would now give you 714 units. Now then let's say that the price started to rebound again and it goes up to, I don't know, $8.50 a unit. Well, you would now have 588 units that year. So you can see where I'm going here with this example. If the market continued to rally and the next year it went even higher, let's say to $12, well that would only give you 416 units that year from your $5,000. And then let's wrap it up now so that we're using just a five-year span. Let's say that it goes back down to $10 per share. So over the five years in this example, you've invested $25,000, right, $5,000 per year. If you only did that now when the price is $10 per share, that only gives you 2,500 shares. But because you used dollar cost averaging and invested during the cyclical trends of the market, you actually now have 2,718 shares worth $27,180. And this is actually translated into a 9% return for really doing nothing but just investing on a schedule. You see, over time, you own more and more units or stock with this method. Usually purchased at a much lower cost and the longer you do this method, the better off your investment portfolio will be. Honestly, I've seen people make hundreds of thousands of dollars doing this simple accumulation strategy, obviously in the right index funds. But when you add this method to a dividend paying stock and you have your dividends purchasing more units when it gets distributed in the fund, you're even further ahead. I mean, this method, it just works. And you don't have to believe me. Look it up online and read the research and science behind it. It's an easy way for the everyday investor to navigate and beat the market in a passive saving strategy. Okay, now that we know dollar cost averaging 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 is a standard practice by most investment firms and works when investments are sold to provide a monthly income. Now this practice is used to guarantee a monthly revenue stream for clients, especially when there are no additional employment pension plans other than OAS and CPP. Now I really need to caution you here with this practice if your advisor wants to do this. The problem is reverse dollar cost averaging has the exact opposite effect on your portfolio. And let me tell you why. Those cyclical trends that helped build your portfolio now work in reverse and believe me when I tell you they can cause severe damage when income is taken out using this method. In fact, if the downturns are deep enough, it can cut your retirement portfolio's life in half. Add to this rising inflation and well, you've got a toxic mix. Retirees will need to withdraw more than they originally anticipated due to reduced purchasing power. And that's not all. Inflation, well, it hits you two ways. First you need to withdraw more from your investments to meet the higher price living expenses, and then the central banks, well, they increase interest rates. And this pushes down the share prices and reduces the value of a retirement equity portfolio. The net effect is that the retiree is forced to withdraw increasingly larger amounts from their investments and must do so from a constantly shrinking asset base. Let me tell you why this happens. When you retire, you can expect to endure between three to five downward swings in 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 reverse dollar cost averaging in a typical retirement horizon of 25 years. That's because you're withdrawing funds and there's not enough in the portfolio to make up the gains when the markets rebound. Sobering fact, right? 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. First thing you should consider is to set up withdrawals from money market funds only. Do not choose fluctuating investments such as equity funds, income trust funds, balance funds, or even bond funds. Abutions from mutual funds, income trust, dividends, and interest payments from bonds should accumulate in that new money market fund instead of being reinvested as you were doing before when you were saving. All periodic withdrawals should come out of this new money market fund only. Now you could also look at real return bonds. These are fixed income assets which provide inflation protection and it might be a good idea to discuss this option with your advisor to make them part of your asset mix. Okay, next thing you could consider is annuities and I've talked about annuities before. The experts always agree that a life annuity and a simple investment portfolio is considered to be the perfect mix for a retirement lifelong income. Last thing you want to avoid the rebalancing game. You don't want to be rebalancing your portfolio too often. Frequent rebalancing causes significant damage to your portfolio and here's a tip. If your withdrawal rate is 5% or less, it's better to rebalance once every four years. Curably at the end of a US presidential election year. Now I know this was a lot to digest and it might be prudent to have a sit down with your advisor to discuss withdrawal rates and what you will need to do if your portfolio suffers a 5, 10 or even 20% loss. Make sure you understand the products you're in to determine not just their potential but also their risk. Indexation and management costs will increase over time and will inevitably put pressure on the portfolio to have increased gains to break even. So always keep this in mind when discussing alternative products with your advisor. Also last thing, determine how your advisor and the firm are being paid and work that cost out annually. Make sure it's worth it. Thanks for listening in today, I'm Christine Ibbitson. If you have a money question that you would like answered, please send me an email through my website at AskTheMoneyLady.ca. Join me next time when we'll talk about more questions than always matter to Canadians. (upbeat music) [MUSIC PLAYING]