If Now, Then How: The Right Way to Get In

When the market is this rough, how you buy fund shares can be almost as important as which fund you buy.

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The Nasdaq Composite has been hacked down nearly 60% during the past year, and the S&P 500 is off about 19% for the same period. So you might be thinking now is a good time to start buying more shares of stock funds. Maybe the shares you buy today will look like eye-popping bargains a year or two from now. Then again, maybe they won't. Either way, if you're going to buy fund shares now, it might make sense to make regular monthly investments -- a strategy usually called dollar-cost averaging -- rather than buying a big slug of fund shares at today's price.

In short, dollar-cost averaging doesn't guarantee a profit, but it does reduce your risk. Investing the same amount each month ensures that you're buying more shares when prices are low and fewer shares when prices are high, essentially the way we all invest in our 401(k) accounts, where a set percentage of cash is yanked out of every paycheck. The idea is that you won't buy at the bottom or the top; rather, your cost basis or average share price will be in between.

It has always been a favorite among folks without a lot of cash to put to work, but it makes sense for a lot of modest and moneyed investors alike.

Smoothing the Road As this hypothetical model shows, investing the same amount each month, or dollar-cost averaging, can dull the barbs of a volatile market
Shares Bought: Lump-Sum Investment	Monthly Share Price	Shares Bought: Dollar-Cost Averaging
12	$10	1
	9	1
	8	1
	7	1
	8	1
	7	1
	7	1
	9	1
	8	1
	9	1
	10	1
	10	1
Value: $120		Value: $120
Cost Basis: $10		Cost Basis:$8.5
Return: 0%		Return: 15%

"A lot of it comes down to risk tolerance. If your genuine risk tolerance -- not what you think it is -- is high, then plunk it all down [in a lump sum]. After all, we invest because we think stocks are going to go up," says Scott Cooley, a senior fund analyst at Morningstar. "The reason I like dollar-cost averaging is that it does reduce risk and builds in a kind of discipline. In volatile areas, cash tends to flow into funds near performance peaks, and it flows out in the valleys. If you're dollar-cost averaging, there's a mechanism that forces you to buy more shares when an area is out of favor."

For instance, if you'd decided to put $5,000 in a stock fund at the start of last year when a frothy market was still going up, you'd have taken a beating. If you'd spread that investment into regular monthly doses, you'd still be in the red, but you wouldn't have lost as much money, and your cost basis would be significantly lower, using a trio of big popular funds as models.

You probably expect the methodical approach to work out better with the (PRSCX Quote)T. Rowe Price Science & Technology fund, the nation's largest tech fund with $9.7 billion in assets and a breathtaking 56% drop during the past 12 months. But the same goes for more diversified stock funds like the $90.5 billion (VFINX Quote)Vanguard 500 Index fund, which tracks the S&P 500 Index, and the $95.8 billion (FMAGX Quote)Fidelity Magellan fund, the nation's largest fund, which is currently closed to new investors. In each case, you'd have lost less money and paid less for your shares on average, according to Morningstar.

Slow and Steady A $5,000 investment on Jan. 1, 2000, vs. the same investment broken up into monthly investments
Fund	Lump Sum/Cost Basis	Dollar-Cost Averaging/Cost Basis
(PRSCX Quote)T. Rowe Price Science & Technology	$3,785/ $58.93	$4,125/ $53.94
(VFINX Quote)Vanguard 500 Index	$4,708/ $135.29	$4,839/$131.13
(FMAGX Quote)Fidelity Magellan	$4,547/ $140.25	$4,632/$135.88
Source: Morningstar. Returns through Jan. 31 and taking funds' expenses into account.

Of course, there's a strong case to make for the lump-sum approach, too.

For instance, if you're going to hold your shares for years, want to put money to work now and are willing to suffer some pain if stocks fall further, the lump-sum approach makes sense. A comparison of two accounts shows that $5,000 invested in these funds 10 years ago would've grown far more than a more methodical approach investing $2,500 immediately and spreading the other $2,500 among monthly investments over the next 10 years.

The Roaring '90s A $5,000 lump sum investment 10 years ago, vs. plunking down $2,500 and the other $2,500 in monthly investments
Fund	Lump Sum/Cost Basis	Dollar-Cost Averaging/Cost Basis
(PRSCX Quote)T. Rowe Price Science & Technology	$51,930/ $26.03	$34,827/ $27.37
(VFINX Quote)Vanguard 500 Index	$25,637/ $38.55	$14,983/$45.69
(FMAGX Quote)Fidelity Magellan	$26,508/ $74.71	$19,189/$79.32
Source: Morningstar. Returns through Jan. 31 and taking funds' expenses into account.

One caveat is that examples like this are compelling, but rare in real life.

"The fact is that most people don't just make a lump-sum investment and leave it, unfortunately," says Morningstar's Cooley. "The average holding period is around three years, so [the long-term hold] is not what always happens."

Another issue you should keep in mind is that the 10 years included in this example were among the best ever. If you're expecting another string of years with above-average gains, the lump-sum choice makes sense. But if you're like a lot of people wondering if we aren't due for a few years with at best modest gains and at worst a few down years, dollar-cost averaging might merit serious consideration.

After all, the methodical approach might not have kept up with the lump-sum tack, but it certainly didn't lose your money either.