Once we 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. The reason for this shift is because we are changing our investment goal from accumulation to income. Without understanding the tools and strategies required to successfully manage these different portfolios, you may never 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 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 (DCA). 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 401(k) plan. Every time you get paid, whether it is every week or every month, the same amount of money is invested in your account.
Why Dollar Cost-Averaging Is So Effective
There are two reasons dollar-cost averaging is such a powerful tool. The first is that it happens without you even needing to think about it or do anything. 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. Overthinking and too much emotion can lead to bad investment decisions.
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 when the market declines at lower prices. We buy low, which is exactly what a smart and successful investor does.
When the stock market inevitably recovers, and your investment portfolio goes up to where it was and beyond, those shares will grow and your investment portfolio will get bigger. By the time you retire, that little retirement nest egg you started with so many years ago can grow into a large enough investment portfolio to supply the income you need in retirement.
Avoid The Trap Of Reverse Dollar-Cost Averaging
However, once we get close to retirement, we need a new approach to investing. When we begin taking money out of our investments, dollar-cost averaging will no longer help us automatically do what smart investors do. In fact, it will have the exact opposite effect. Continuing to do what we did to successfully 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.
If we simply reverse the process after we retire and begin selling our investments at regular intervals to raise cash and replace our paycheck, we are going to fall into the trap of reverse dollar-cost averaging. With reverse dollar-cost averaging, we remove the same amount of money every week or every month from our investments whether the market is up or down.
The problem is 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.
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 unacceptable risks and can put you in jeopardy of running out of money before you run out of living. Understanding the importance of dollar-cost averaging and how it works is crucial to building an appropriate and well-structured retirement plan.
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Disclosure: Securities and investment advisory services offered through NEXT Financial Group, Inc. Member FINRA SIPC. Hafner Financial Group is not affiliated with NEXT Financial Group, Inc.