3 Things 10-26-26

Thing One

A Closer Look At Dollar Cost Averaging

Most investors have heard the advice to invest a fixed amount of money at regular intervals, regardless of what the stock market is doing. It's called dollar-cost averaging, and it's a perfectly sensible approach to investing. But there's an important distinction between a strategy that helps investors make good decisions and one that actually produces the highest returns.

A recent Investopedia article examined this question by comparing two approaches to investing in the S&P 500. In one scenario, an investor put $500 into the market every month for 20 years, beginning in 2000. That's a total investment of $120,000. By the end of the period, the investment had grown to approximately $280,800. Not bad.

But consider what happened when the same $120,000 was invested all at once at the beginning of that period. By the end of the 20 years, the investment had grown to approximately $448,200. That's nearly $167,400 more, or roughly 60% greater ending wealth. The comparison excludes certain fees and dividends, but the point is worth considering. It's also important to recognize that these results are specific to the period examined. A different starting date, particularly one immediately preceding a prolonged market decline, could produce a very different outcome. The example illustrates the potential advantage of investing earlier, not a guarantee that lump-sum investing will always outperform.

Why such a dramatic difference? Because while dollar-cost averaging allows investors to buy more shares when prices fall and fewer when prices rise, it also means some of their money remains on the sidelines. And since the stock market has historically risen over longer periods, money sitting on the sidelines has an opportunity cost.

Now, there's an important distinction here. Someone who earns a paycheck and invests $500 every month isn't necessarily choosing dollar-cost averaging over lump-sum investing. They're simply investing money as it becomes available, which is exactly what I would encourage them to do. But someone who inherits $120,000 and decides to invest it in $500 monthly increments is making a very different decision. That person is deliberately keeping a substantial amount of money out of the market, potentially for years.

Of course, the comparison works differently when markets decline shortly after a lump-sum investment. Someone who invested everything just before a major downturn might have been better off spreading those purchases over several months. That's the appeal of dollar-cost averaging. It reduces the risk of investing everything at precisely the wrong moment, and perhaps more importantly, it reduces the emotional burden of making that decision.

And that emotional consideration shouldn't be dismissed. An investment strategy that produces the highest theoretical return isn't necessarily the best strategy for someone who might panic and sell during a 25% market decline. If gradually investing a large sum helps someone stay committed to the market rather than abandoning the plan altogether, there's real value in that.

But we shouldn't confuse reducing anxiety with maximizing expected returns. Historically, the stock market has rewarded investors for having their money invested, not for keeping it in reserve while waiting for a more comfortable entry point. And while nobody knows what the market will do over the next six months, the odds of benefiting from immediate investment generally improve as the investment horizon lengthens.

For someone with a long investment horizon, adequate cash reserves, and an appropriate tolerance for risk, investing a lump sum immediately may offer a better opportunity for long-term returns. But that doesn't necessarily make it the right choice for everyone. Spreading an investment over time can provide some protection against unfortunate timing and, perhaps more importantly, make it easier to remain comfortable with the decision. Ultimately, the choice should reflect an investor's circumstances, objectives, and temperament, along with an appropriate allocation among stocks, bonds, and cash.

Dollar-cost averaging remains a valuable tool, particularly for investors building wealth through regular contributions. But when the money is already available, it's worth asking whether spreading out the investment is improving the financial outcome or simply making the decision feel more comfortable.

Those are two different objectives, and understanding the difference can be worth a considerable amount of money.

Thing Two  

Having A Million Dollars Is Not A Retirement Income Plan

For years, Americans have been encouraged to focus on accumulating a certain amount of money for retirement. For many, $1 million has become something of a psychological milestone. And while accumulating that much money is certainly an accomplishment, it doesn't answer the question that matters most once you stop working: How much income can that money reliably provide, and for how long?

Consider two retirees, each with $1 million in retirement savings. Both are 65 years old, but one receives $45,000 annually from Social Security and a pension, while the other receives just $25,000 from Social Security. Both want to spend $80,000 annually. The first retiree needs to withdraw $35,000 from investments each year, or 3.5% of the portfolio. The second needs $55,000, or 5.5%. Same million dollars, but two very different retirement pictures.

Those differences become even more significant when inflation, taxes, and market performance enter the picture. Someone retiring at 65 could easily spend 25 or 30 years in retirement. At an average inflation rate of 3%, something that costs $80,000 today would cost approximately $144,500 in 20 years. Social Security benefits generally receive cost-of-living adjustments, but not every source of retirement income keeps pace with inflation.

So where should a retirement income plan begin? Start by estimating annual spending, separating essential expenses such as housing, food, insurance, and healthcare from discretionary expenses such as travel and entertainment. Next, subtract predictable income from Social Security, pensions, and other sources. The difference is what your investments must provide. If annual spending is $80,000 and predictable income is $45,000, the portfolio needs to produce $35,000. On a $1 million portfolio, that's an initial withdrawal rate of 3.5%. That calculation provides a starting point for evaluating whether the plan is sustainable.

There's also an important distinction between investment income and withdrawals from investments. Suppose you withdraw $40,000 annually from a $1 million portfolio. That's a 4% withdrawal rate, but it doesn't necessarily mean your investments are earning 4%. Some of that money might come from dividends and interest, some from selling appreciated investments, and some from selling investments at a loss. If the portfolio declines 15% in a particular year, the bills still need to be paid. And withdrawing money from a declining portfolio can make recovery more difficult.

One practical approach is to establish a reserve for near-term withdrawals. Someone needing $40,000 annually from investments might consider keeping one to two years of that amount, or $40,000 to $80,000, in cash or short-term instruments. This could reduce the need to sell stocks during a market decline. Longer-term investments could then be positioned for income and growth, with a plan for replenishing reserves as circumstances permit. The appropriate amount depends on the retiree's other income, risk tolerance, and overall portfolio.

Bonds can also play an important role, although there's a meaningful difference between owning individual bonds and bond funds. An individual high-quality bond held to maturity generally provides predictable interest payments and the return of principal, assuming the issuer meets its obligations. Bond funds have fluctuating share prices and no fixed maturity date. Both have their place, but they don't behave exactly the same way when interest rates change.

Taxes introduce another layer of complexity. A retiree with $1 million in a traditional IRA doesn't really have $1 million available to spend because withdrawals are generally taxable. Someone with the same amount in a Roth IRA may have substantially more spendable wealth, assuming withdrawals qualify for tax-free treatment. A useful part of the planning process is identifying which accounts will fund withdrawals each year, while considering tax brackets, required minimum distributions, and the potential tax consequences of those decisions.

Then there's Social Security. Someone eligible for a $2,500 monthly benefit at a full retirement age of 67 could increase that benefit to approximately $3,100 by waiting until age 70, before future cost-of-living adjustments. That's roughly $7,200 in additional annual income for life. But delaying means giving up several years of payments, so the decision should account for life expectancy, marital status, other income sources, and immediate cash needs. These figures are illustrative; actual benefits depend on individual circumstances.

Finally, an income plan shouldn't be something developed at retirement and then forgotten. At least annually, compare actual spending with the original estimates, review the portfolio's performance and withdrawal rate, and determine whether adjustments are necessary. That might mean replenishing cash reserves after a strong market year, reducing discretionary spending following a prolonged downturn, or reconsidering withdrawals to manage taxes.

None of this means retirees need complicated portfolios or elaborate financial products. In fact, simplicity can be an advantage. But retirement requires a different mindset from the accumulation years. When you're working, market declines can present opportunities to buy investments at lower prices. When you're retired and withdrawing money regularly, those same declines can present challenges that require thoughtful management.

A million dollars might be more than enough for one retiree and inadequate for another. The difference isn't necessarily investment performance. It's how much income is needed, where that income comes from, how taxes and inflation affect it, and how the portfolio is managed through difficult markets.

The goal shouldn't simply be to retire with a large number on an account statement. It should be to have a practical plan that identifies how much income you need, which sources will provide it, what you'll do when markets decline, and when you'll revisit the plan. That's what turns retirement savings into retirement security.

Thing Three

Just A Thought  

“It is impossible for a man to learn what he thinks he already knows.” - Epicetus