In the kind of volatile stock market we’ve experienced during the past couple of years, dollar-cost averaging can be a valuable tool. Its main appeal is to impose discipline on the investor, not to open the door to some magical mathematical way of making money grow on trees, as some of its most enthusiastic followers claim.
What is it, anyway?
It is a simple, no-fuss investing technique that involves putting the same amount of money into the market at regular intervals, such as $100 or $1,000 a month. If you have a 401(k) or similar plan at work, you’re probably using dollar-cost averaging even if you didn’t know the term.
As a disciplinary tool, it forces the investor to keep at it through thick and thin. If you simply let your cash accumulate and then invest when the moment seems right, you’re likely to be scared off when the market is down, while that is actually the best time to invest. With dollar-cost averaging set on automatic, nerves aren’t as much of a problem.
There’s also a mathematical argument. An equal sum will buy more stock or mutual fund shares when prices are down, and fewer when prices are high. Over time, this minimizes your average cost per share, boosting returns a tad.
But not always. Critics are quick to point to periods when dollar-cost averaging has backfired, leaving investors with less than if they’d committed the whole amount as a lump sum. That’s likely when the market marches steadily upward, providing no down months with bargain prices.
Taken to an extreme, this criticism involves an apples-to-oranges comparison. If you had $10,000 to invest, you’d almost certainly be better off investing it all at once rather than pacing it over 10 years. Too much would be left on the sidelines for too long, missing gains that could be enjoyed in the meantime.
But which is better? Investing $10,000 at once or pacing it out over a longer period, such as 12 months? Since the market does rise in the average year, the lump sum should do better, on average.
But, of course, the market does fall some years. In those, the piecemeal investments made with dollar-cost averaging might do better, since some months’ contributions would be made after prices had fallen.
For many investors, it’s just too nerve wracking to put a large sum into the market all at once. Many procrastinate, missing potential gains in the meantime. This year, for instance, market-tracking funds like the Vanguard 500 Index fund (Stock Quote: VFINX) and Dow Diamonds (Stock Quote: DIA) plunged from January to March, then recovered.
And in many cases, the debate over lump sum investing vs. dollar-cost averaging is moot, because investors just don’t have a lump sum. It would definitely be self-defeating to reverse the reasoning, forgoing dollar-cost averaging all year in order to put in a lump sum later. Too much money would be sitting on the sidelines.
The bottom line is that if you have a big sum, investing it all at once could well pay off better than parceling it out. But the dollar cost averaging approach works well often enough that you shouldn’t feel bad about using it if plunging in will leave you sleepless. Use the Savings, Taxes and Inflation Calculator to see how investments can grow over time.
No-load mutual funds are generally the best choice for anyone investing modest sums at regular intervals, because there are no fees for investing if you do it directly with the fund company. With stocks, trading commissions can eat away at your principal, stunting returns.
Just imagine if you paid a $10 commission for each month’s $100 investment. The same goes for load funds that carry up-front sales charges.
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