I think Billy was jealous of Kathleen. You saw all the toys she had. In the scene where she dies, Billy is trying to get the toy away from Kathleen, but she won't let go of it. It seems to me that Billy intentionally throws Kathleen into the lake. I don't think he meant to kill her, probably just scare the heck out of her. But she didn't come back up out of the water. The fact that obviously no one else in the family knew that Billy had caused her death, it is clear he never told them what had happened. I assume the rest of the family decided she fell in the water on her own. So Billy was living with the guilt of killing his sister. In an attempt to relieve his guilt, he makes the tombstone to place in the lake where she died, and made the wax doll, probably in an attempt to "care" for her and try to gain her forgiveness for what he'd done. Since Billy is Kathleen's (wax doll) protector, anyone who gets near her is killed by Billy. I don't think the dream about Richard was anything other than more of Billy's guilt that had consumed him.
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