SMART INVESTING - Dollar-cost averaging keeps investors in market
Copyright © 2007, Chicago Tribune and The Associated Press
August 2, 2007
NEW YORK - With the stock market resembling more bronco than bull recently, investors accustomed to a steadier ride might be tempted to step aside and wait for calm to return.
But the stock market's mostly smooth run in the past year was a break from more normal levels of turbulence. So if volatility begins to visit Wall Street more regularly, some investors looking to get into the market might consider a strategy known as dollar-cost averaging. It's designed to let investors wade into an investment gradually, without the risk of making one lump-sum investment.
Investors planning to buy a stock, for example, would determine a schedule and then invest the same amount each time, regardless of the share price.
The fixed contributions are meant to help investors look past fluctuations in the market. And while the stock market's recent tremors likely caused a good amount of investor angst, those who let emotions dictate their investment decisions could ultimately be left feeling the biggest regret.
"Dollar-cost averaging sort of helps work against human nature, those emotions of greed and fear. Greed and fear are your worst enemies in the market," said Tim Krause, director of risk management at Zecco Trading, an online brokerage.
Financial advisers often counsel investors to maintain a diversified portfolio and remember that stocks generally work best as long-term investments.
Adam Bold, chief investment officer of The Mutual Fund Store, an investment management company, contends investors who sell because of a sudden market movement are often doing themselves harm.
"They say 'When the markets look good then I'm going to put the money back in.' The problem is the markets never look good," he said, noting that Wall Street either recovers and makes it more expensive for the investor to jump back in or it moves down and makes hesitant investors likely to miss a market bottom.
"What ends up happening is they never get reinvested. It's too subjective and too difficult," he said, referring to forecasting the market's day-to-day moves. "You're much better off to set your schedule and stick to it."
So for investors who determine they acted hastily in taking their money off the table, dipping their toes in the market with incremental investments might help allay concerns about short-term movements.
"If you put a chunk in and things go up then you're happy because you got a portion of your money in and if things go down then you have some of your powder dry for when prices go lower," said Bold.
While the merits of dollar-cost averaging can stir debate among investors, one of its pluses is that it relies on the widely praised idea of making regular contributions.
"The academic literature has been against it historically, but most of these studies were done in a rising market so naturally it would've been greater," said Krause, referring to the returns seen from putting a lump sum in the markets compared with gradually adding money.
Investors who make regular contributions, such as through a 401(k) plan, have both time and compounding interest on their side and are likely to see their returns outpace those of less disciplined investors or even those who make bigger contributions but over a shorter time period, research has shown.
Krause noted, however, that many investors simply don't have a big chunk of money to put into an investment.
"The main benefit to me is that most of us aren't very good at market timing. It reduces peoples' fears at times like these when the temptation is just to dump everything. At least you know if you're averaging in, over the long haul you're going to achieve a beneficial average price," Krause said.