Perils of Reverse Dollar Cost Averaging in a Volatile Market


We can regularly anticipate bad weather during hurricane season.  It hits the coastlines to some degree almost every year.  We feel for friends, clients and loved ones who are impacted by the devastating storms in South Florida and want to offer our support for any who may need a hand in this troubling time.
Every year we like to communicate with clients to get ready for a hurricane in the markets.  When summer draws to a close we head into the worst months of the year.  September lived up to its billing as the worst month of 2022. Currently the U.S. stock markets are down across the board.  What many did not anticipate was how badly the bond market might fare.  Most years when stocks are down 20% or more, we can protect portfolios by owning bonds as a safe haven to wait out the storm.  2022 has proven to be the exception, but with a silver lining.

Rising Interest Rates May Severely Damage the Economy

Interest rates have risen at a faster pace this past year than any time this past century.  One-year treasury yields are close to 10 times what they were at the beginning of the year, with rates starting under 0.5% and now yielding over 4.0%.  This has sent bond values plummeting in the short run and caused a strain on the financial system as those who have borrowed to fund business operations, buy cars & homes or other items may now find themselves more stretched than they anticipated.  The leverage in the system helps to multiply the positive and negative effects of interest rate moves.  We have already seen the tightening in Europe start to threaten prevailing systems with Credit Suisse on the verge of a Lehman Brothers moment.
We can see below that over the last 50 years, we have never encountered two down years in a row for the bond markets or a drawdown of this magnitude before (over 15% to date for the bond market in general).  Longer term bonds have suffered more during this period while shorter term & floating rate bonds have suffered less.
What may be harder to see is that the best bond markets of the past followed a similar period of bond decline.  Bond yields typically top either just before or just after a yield curve inversion. When this inversion takes place, yields are usually not far away from the top of the cycle.  As we noted from our last article, the bond market rewards investors handsomely from this topping process to the end of the cycle.  Losing 15% to 20% or more investing in bonds may not be fun during the rate hiking process (we have underweighted bonds but not eliminated bonds in more conservative portfolios over the last year). Bonds prove profitable after rates have peaked and protect from these selloffs heading into recessions.  In some cases, the differential is over 50%.  For more on this please read Time to Refill the Barn?

Why Do Investors Choose to Lose Money After Inflation?

Inflation can prove to be much more damaging than rising interest rates.  Talk to someone from Venezuela or Argentina, and they can tell you what it is like to see savings reduced to nothing while invested “safely” in banks earning a high interest rate.  Rates in Argentina are currently over 60% but with inflation exceeding 70%, you still lose. Negative “real” interest rates are common in most countries today.  Commodities including energy, precious metals, agricultural products and the like have been the only place to invest recently with the potential to overcome high inflation.  Through the first 9 months of the year, commodities have returned over 13% while cash has returned less than one percent and everything else has been negative.  This is starting to change, with inflation moderating and interest rates increasing to levels where investors can win again.
Inflation sometimes cures itself as consumers choose to spend less. Previously when bonds yields became negative adjusted for inflation, Central Banks worked to slow consumer demand and raise rates to levels above the prevailing inflation rate.  Over the past fifty years in the U.S., the inflation rate moved below these higher interest rates most of the time before interest rates peaked.  This can be seen in the graph below.

Reverse Dollar Cost Averaging – A Costly Strategy in a Volatile Market

Most are familiar with the benefits of Dollar cost averaging.  Let’s say someone wants to buy Exxon Mobil stock at $90 a share starting in October 2012.  $100,000 would have purchased approximately 1111 shares.  The value of the shares at the end of September at $91.92 a share would equate to just over $102,000 (a gain of slightly over 2%).  Investing $10,000 a year every October would buy more shares when Exxon is down and less when it moves higher.  This alternate strategy would buy over 1452 shares which would be worth over $133,500 today (a gain of over 33.5%).  This is a difference of over 3% a year in excess gains. This strategy works well in volatile markets and best in down markets when they recover.

Locking in Losses – Selling More Shares at Lows

Many retirees fail to realize they are falling victim to “Reverse Dollar Cost Averaging”.  They sell more shares when the market is down, locking in their losses.  A good fix for this fallacy is to only sell those holdings that are less volatile (rebalancing periodically to increase the allocation to more conservative holdings). In the past, the “safe” part of the portfolio has been bonds and other types of fixed income, but these “safe” investments have proven more volatile this past year as well.
Just a year ago, it made little sense to own cash equivalents when short term paper earned less than one percent and inflation was running hot.  Until rates exceed the inflation rate, we feel commodities and other “inflation protection” options will continue to prove more profitable. Soon this may change, however.  More options are available to us now that rates are increasing.  Interest rates for short term paper are 10 times higher than a year ago in some cases, opening-up our treasure chest of planning strategies.   With higher rates, we can take advantage of strategies that did not make sense a year ago, but may prove much more profitable for investors over the coming years.

An “Income Harvesting Strategy” Analysis

Volatile markets encourage investors to shift to cash, bonds and precious metals.  Gold and precious metals prove to be the most inflation resistant of these options. Cash, CDs and bonds made little sense until recently, because “real” interest rates were still negative.  But now that treasury bonds and CDs are paying over 4%, we can see a time soon approaching when the rate of interest will exceed inflation and we will be rewarded for owning debt instruments again.  The Federal Reserve has vowed to beat down inflation by raising these rates and slowing the economy.  Interest rates may end up topping somewhere around 5% or higher, sooner or later.

Today it is making much more sense to start looking at additional protection strategies for portfolios.  “Income Harvesting” provides a “safe” storehouse of future withdrawals from cash equivalents during times of economic famine.  When cash equivalents yield more than the inflation rate, we especially like the strategy.  Locking in the income needed for one, two, three years or more provides income needed without having to sell off other portions of the portfolio at a loss, reducing the overall portfolio risk in the process.  Those who are less familiar with the strategy may like to read more by following this link.

During market downturns, the overall portfolio loses less value than the other strategies (as shown in the chart below).  During recoveries, it lags but not as much as a “Reverse Dollar Cost Averaging” strategy which is also inherently riskier.  Now that we can receive 4% or more from this storehouse of future funds, we can look at laddering a portfolio of CDs and treasuries to provide what may be needed if we encounter a longer downturn in markets and the economy, similar to the early the 1973-1974 period or the 2000-2003 period.  Obviously, we like higher rates better than lower rates, but by laddering the portfolio we may also be able to realize higher rates over time as well.  More on laddering bonds can be found by following this link.

Historical Performance of the “Income Harvesting Strategy” versus “Reverse Dollar Cost Averaging”

Our first two time periods show how the alternate strategies compare to buying and holding the S&P 500 Index.  In these scenarios, we are assuming a family starts with a $2 million portfolio and draws 6% from the portfolio over a period of five to seven years.  While we do not generally recommend a withdrawal strategy exceeding 4% of a portfolios value, this 6% rate is easier to model because it accounts for a withdrawal of $10,000 a month of retirement cashflow.
We compare the strategies by assuming the “safe” portion of the portfolio is invested in laddered CDs and treasury bonds earning an average of 4%.  This is what we can receive currently from this type of portfolio and is less than what was available during most of the 2000s, but may have been harder to achieve during the 2010s and 2020s to date prior to recent rate hikes. Withdrawals can be assumed to be spent but for the purposes of this analysis we are showing them sitting in a separate account earning no interest.
During the “” bust and the financial crisis, the “Income Harvesting Strategy” allowed investors to avoid selling stock investments at a loss with withdrawals coming from a laddered portfolio of CDs, treasury bonds and higher interest money markets. Losses in the “no-withdrawal” example exceeded 40% in both periods, but recovered more quickly as well.  The “Reverse Dollar Cost Averaging” strategy shows a better return than “no-withdrawal” during the downturns and might be somewhat more appealing while the markets are weak, but it also fails miserably during the recovery phase.  We can see by looking at the “Income Harvesting Strategy” that the overall portfolio suffers less in the downturn but also rallies less during the recovery phase.  Returns are roughly similar to the “no-withdrawal” example but prove superior when adjusting for risk levels, considering much of the portfolio is “safely” stored away for future income needs.
If we encounter another period similar to the early 2000s or even the financial crisis and need to draw income from the portfolio, the “Income Harvesting Strategy” can be seen to be superior.  The strategy outperforms the “no-withdrawal” strategy until the markets have recovered and outperforms the “Reverse Dollar Cost Averaging Strategy” by a wide margin. Utilizing the “Reverse Dollar Cost Averaging Strategy” lost this family $200,000 or more in these two scenarios versus the other two strategies, equating to a slippage of over 1.75% per year.

When “Income Harvesting” Is Less Advantageous

From June 2013 through July of 2020, yields from CDs and treasuries with maturities less than 5 years started at one percent or less, and continued to decline.  A 4% average yield could only be found if investors reached for yield by extending maturities or shifting to lower rated corporate bonds. Doing so during this period failed to reward investors as much as past periods as the increased risk levels made the bond portion of the portfolio take on volatility characteristics more similar to equities.  The risk level in a portfolio increases when reaching for yield.
“Income Harvesting” until recently was only viable for families with the lowest “Family Risk Index” numbers as it was close to impossible to provide the returns needed for those with higher “Family Risk Index” numbers while owning a large percentage of bonds and CDs.  More on the “Family Risk Index” can be found by following this link.
Moreover, because this period was mostly positive, the “Reverse Dollar Cost Averaging” strategy slightly outperformed the “Income Harvesting Strategy”. Some will argue that the “Income Harvesting Strategy” attained the same results with less risk, but the risk levels were continually increasing in order to attain the 4% average yield bogey. The rising stock market did not help practitioners of an unmodified “Reverse Dollar Cost Averaging” strategy, however.  The chart below shows that this strategy lost close to 2.5% per year when comparing to a “no-withdrawal” strategy.

From the Pandemic to Today

A practice of maintaining a diversified portfolio, withdrawing from the most stable investments in the portfolio and rebalancing periodically proved to be adequate during the period of low interest rates from the mid 2010s to approximately a year ago. For many, it was the only way to achieve the level of cash flow wanted for retirement and maintain a bogey above the requisite “Family Risk Index” percentage.

“Income Harvesting” had grown less beneficial as interest rates decreased and the markets increased in value.

The past year’s rate hikes have transformed the landscape

Looking back over the past year, commodities and other Inflation Hedges have outperformed.  The chart below shows that year to date, focusing on inflation protection has been the best strategy.  At some point, we feel precious metals and treasury bonds may prove to provide the best protection for investors as inflation concerns become less worrisome than the threat of recession and economic instability.  In the meantime, looking at repositioning portfolios to an “Income Harvesting” strategy may provide the stability many are looking for.
For those interested in pursuing an “Income Harvesting” strategy, please feel free to email or give our office a call.  Laddering a portfolio of CDs and treasury bonds may prove to be more beneficial than many people currently realize, especially if we head into a deep recession as many currently fear.
Joe Franklin, CFP®President, Wealth AdvisorFranklin Wealth Management,

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