In my last article I promised I would show you some tools and strategies you could use to create an income stream for retirement that is both insulated from stock market volatility and allows your spending to increase so it can keep up with inflation.
I’ll start by giving you the most important tool; your mindset.
Once you begin the transition from working to retiring, there is a huge shift that needs to take place in the way we think about our investments. Yet I’m sure most people don’t fully appreciate just how significant that shift needs to be.
The reason for this shift is because we are changing our investment goal from accumulation to income.
And without understanding the different tools and strategies required to successfully manage these different portfolios, you’ll never be able to achieve the confident mindset you need to feel secure about retiring.
Investing Is Easy When We’re Younger
When we’re younger and building our nest egg, investing is really pretty simple. It’s kind of like the wind is at your back, you’re walking downhill, and traffic lights are always turning green. The reason for this is when we simply put money into the market on a regular basis, the way we do with our 401k plan, the market has a way of rewarding us. Over time we are often rewarded quite handsomely.
This is due in large part to a principle called dollar cost averaging.
Dollar cost averaging is a technique where you invest the same amount of money at regular intervals regardless of whether the market is up, down or sideways. The only thing you concern yourself with is making sure more money is added on a regular basis.
This is exactly what you’re doing in your 401k. Every time you get paid, whether it is every week or every month, the same amount of money is invested in your 401k account.
Why Is Dollar Cost Averaging So Effective?
I think there are two reasons dollar cost averaging is such a powerful tool. The first is that it happens automatically. It happens without you even needing to think about it or do anything.
First, because it happens automatically, dollar cost averaging helps take some of the second-guessing and emotion out of investing. You don’t need to read the paper and decide if now is the right time to invest or not, and you’re not deciding whether to invest based on how you feel about things.
Dollar cost averaging is an effective tool because it is an automatic process that takes the THINKING and EMOTION OUT of investing.
Second, with dollar cost averaging, you automatically buy more shares when the market is down because the shares are less expensive and your dollars go further.
When we invest the same amount of money every month or week and the shares are less expensive, we accumulate more shares at lower prices. We buy low. And isn’t this exactly what a smart and successful investor does?
When you are in the accumulation stage of investing, market declines can actually work in your favor if you let them. Market declines give you the opportunity to benefit from dollar cost averaging and accumulate more shares at lower prices.
And when the stock market inevitably recovers, and your investment portfolio goes up again to where it was and beyond, those shares will grow and your investment portfolio will get bigger. And by the time you retire, that tiny little retirement nest egg you started with so many years ago can grow into a large enough investment portfolio that it can supply the income you need in retirement for the rest of your life.
Avoid The Trap Of Reverse Dollar Cost Averaging
However, once we get close to retirement, we are going to need to shift our thinking. We are going to need a new approach to investing. This is because once we begin taking money out of our investments, dollar cost averaging will no longer work for us. Dollar cost averaging will no longer help us to automatically do what smart investors do. In fact, it will have the exact opposite effect.
Continuing to do what we did so successfully to build our retirement nest egg will completely undermine our investment portfolio once we stop working and begin living off our investments.
We need a new strategy.
What will happen if we simply reverse the process after we retire and begin selling our investments at regular intervals to raise cash and replace our paycheck, is we are going to fall into the trap of reverse dollar cost averaging. This is the exact opposite of dollar cost averaging.
With reverse dollar cost averaging we remove the same amount of money every week or every month from our investments. We do this whether the market is up or down. The problem is that when the market is down, we will need to sell more shares to raise the same amount of money.
Thus, if the market goes down and stays down for a long period of time we can significantly erode our retirement nest egg. And if your retirement nest egg is getting smaller, the income you can take from it will decline as well.
If You’re Not Reverse Dollar Cost Averaging, Then What?
You can see that putting the process in reverse and simply taking money out of your investment portfolio to supplement your spending exposes you to risks that are unacceptable. It can put you in jeopardy of running out of money before you run out of living.
One of the most important benefits my clients get from working with me is the confidence that they will be able to maintain their standard of living throughout retirement. In my next article, I’ll give you the first of a number of other important tools and strategies that will help you achieve that same benefit.