The Benefits Of Dollar-Cost Averaging

October 13 06:05:02 AM, Yahoo News

Investor's Business Daily - When autos go on sale, more people tend to want to buy. The same with clothing and TV sets and soft drinks.

But when stock prices fall, many investors move their money out of stock funds. They end up buying high and selling low. That reduces long-term returns.

Dollar cost averaging can help you dodge this trap, especially in a sell-off. You invest a fixed amount at regular intervals in mutual fund shares. You end up buying more shares when prices are low, fewer shares when prices are high.

That shrinks your average cost per share. It can also produce better results when you eventually sell.

If you regularly invest in your company's 401(k) plan, you already engage in dollar cost averaging.

Suppose a hypothetical Alicia Brown contributes $12,000 a year to her 401(k). That's $1,000 a month. She gets paid twice a month so $500 comes out of each paycheck and goes into her 401(k).

So Brown puts $500 into her favorite large-cap growth fund twice a month.

When that fund is priced at $50 a share, Brown buys 10 shares. If it trades at $48 two weeks later, Brown's $500 buys 10.42 shares.

By buying more lower-priced shares, Brown will have larger profits (or a smaller loss) when she sells.

What if you suddenly have a lump sum of money? Say you get an inheritance.

Should you invest all at once? Or should you use dollar cost averaging to invest gradually?

"Historically, investing a lump sum has been a better choice most of the time," said Scott Donaldson, a senior investment analyst in Vanguard's Investment Strategy Group.

That's because the stock market has gone up more than it has gone down. Investors who tiptoed in have been out of the market on some days when prices rose.

Timing the market with mutual funds is hard. You might invest your lump sum just before a steep drop. Then you may have to wait weeks or years before showing a profit.

Reducing Risk

So dollar cost averaging is a way to reduce your risk vs. investing a lump sum. "Some people are uncomfortable putting their money in all at once," Donaldson said.

Dollar cost averaging typically beats trying to time the market by going to cash during a sell-off. A key danger in a timing strategy is that you'll be out of the market when it rallies.

Unless they have a sound, proven rules-based strategy, those who try to time mutual fund buys and sells are prone to missing out on gains in new bull markets. Those lost gains commonly outweigh losses that timers avoid on the way down.

But dollar cost averaging does not take your existing shares out of the market. Instead, it puts new money to work at intervals.

Further, dollar cost averaging's psychological appeal can help you avoid succumbing to the risky strategy of timing, Donaldson says.

Suppose you put a large amount into stock funds, which quickly drop 20% or 30%. "Some investors would suffer from buyer's remorse and bail out," Donaldson said.

People usually wait too long before getting back in. They lose out on key chunks of long-term returns that stock funds have delivered.

The same is true if fear of a bear market keeps you from ever investing your lump sum in stock funds.

"With dollar cost averaging, you can avoid being immobilized by fear," Donaldson said.

In taxable accounts and IRAs, you can choose your own timetable. You can kick in monthly. You also can invest every other month, every quarter or at whatever interval you like.

The more you spread out your injections of new money, the less risk you have of buying many shares at or near a market top. Spreading your new investments also reinforces the attitude you should take that stock funds are meant to be long-term investments.

The more nervous that short-term volatility makes you, the longer your investment intervals can be. That slows down how quickly new money is exposed to market risk.

For stock funds, you might take a year or longer to fully invest the amount you intend to commit.

"Dollar cost averaging works best with volatile asset classes, such as stocks," Donaldson says. Bond fund share prices usually don't fluctuate as much. You might as well invest all at once or within a short time period, if you want a modest allocation to fixed income.

Simple Strategy

Implementing a dollar cost averaging strategy can be simple. Say you decide to roll over money from a 401(k) account to an IRA. Despite today's market, you'd like to invest in a specific stock fund whose long-term prospects you like.

You can put that $100,000 into a money market fund with that same fund family. You can usually arrange automatic transfers of a set amount from the money market fund to selected stock funds, on the schedule you prefer.

Source

Related articles

More Business
back to top
Your Ad Here
News Buzz © 2007. About Us Politics | Entertainment | Business | Tech