Dollar Cost Erosion
The Dollar Cost Averaging approach to investing involves investing a fixed number of dollars in stocks or mutual funds at regular intervals, regardless of market performance. The result is that you buy relatively more shares when the market is down and fewer shares when the market is up. Your average cost per share will be somewhat less than the average price for the dates on which you bought the shares.
One might think a similar benefit would result from dollar cost averaging out of the stock or mutual funds in order to obtain a regular income. According to traditional averaging analysis, if stocks historically have an average annual return of 10% and inflation averages 3% annually, then it would seem correct that you could withdraw 7% from your portfolio without depleting the principal.
Table 1
| Year |
Initial Capital |
Total Return@10% |
Income @7% |
Final Capital |
| 1 |
$500,000 |
$50,000 |
$35,000 |
$515,000 |
| 2 |
$515,000 |
$51,500 |
$36,050 |
$530,450 |
| 3 |
$530,450 |
$53,045 |
$37,131 |
$546,363 |
The results of Table 1 seem to show that dollar cost averaging out of stock in order to achieve an income of 7% a year would not diminish the value of your holdings.
However, the results of a study, called the Trinity Study, proved the contrary. Three professors from Trinity University looked at a thirty-year time period (1946-1977) of selling stocks for income and keeping up with inflation. In order to provide 6% income increasing annually with inflation, they concluded that a portfolio of 100% stocks would only be able to maintain capital 57% of the time. A portfolio of 50% bonds and 50% stocks would be able to do so only 35% of the time. The findings of the study were based on actual historic data, not average historic data.
Let’s say you need to sell your stocks in order to have $3,600 per month. As the following table illustrates, the price of the stock will fluctuate each month, so some months you will have to sell more stocks to get $3,600 income, and some months you will sell fewer shares to get the same $3,600.
Table 2
Dollar-Cost Averaging Out of Investments
| Month | Price per Share | Income Needed | Number of Shares Liquidated |
| January | 12 | $3,600 | 300 |
| February | 15 | $3,600 | 240 |
| March | 9 | $3,600 | 400 |
| April | 18 | $3,600 | 200 |
| May | 20 | $3,600 | 180 |
| June | 25 | $3,600 | 144 |
| July | 24 | $3,600 | 150 |
| August | 25 | $3,600 | 144 |
| September | 20 | $3,600 | 180 |
| October | 22 | $3,600 | 164 |
| November | 30 | $3,600 | 120 |
| December | 36 | $3,600 | 100 |
| Totals | - | $43,200 | 2,322 |
The average price per share during the year is $21.33(12 +15+9+18+20+25+24+25+20+22+30+36 /12 = 21.33)
The average selling price is Total Income (value of shares sold) divided by Total shares liquidated = $43,200/2322 = $18.60.
The above example shows us that the average selling price is less than the average price per share. Dollar cost averaging out of a stock or fund in order to have a set income actually results in “dollar cost erosion.” To meet income needs, when the price is low, more shares must be sold.
