Over the past few years, emotion has ruled the stock market. Swept up first by greed and then by fear, investors bought high and sold low. When the market bottomed out in mid-September, many felt so burned that they hesitated to get back in--and so lost out on the 23% rise of the past four months.
Fortunately, there is one well-known investing method that eases anxiety instead of provoking it. Better yet, it naturally gets you to do the sensible thing: Buy fewer shares when prices are high and more when prices are low. It's dollar-cost averaging--the old and blessedly simple technique of putting the same amount of money into the market in regular intervals, such as every week or month. "Dollar-cost averaging is a time-tested, proven, highly reliable method to gather wealth," says Frank Armstrong III, president of Investor Solutions in Miami.
Dollar-cost averaging is a way of life for everyone who contributes to a 401(k) plan by payroll deduction. But like any other handy tool, it can be overused. Top financial planners say that some popular notions about dollar-cost averaging don't stand up to scrutiny. For instance, many investors--and even planners--believe that dollar-cost averaging is a good way to invest lump sums. That's often not true. Investors may also believe that dollar-cost averaging immunizes them against the risks of volatile stocks. Again, not true. But it is an excellent--and underused--way to liquidate a stock portfolio or exercise a batch of stock options.
If you're dollar-cost averaging through a 401(k) or other defined-contribution plan, the smartest thing to do is very little. In other words, resist the temptation to time the market by raising or lowering your payroll contributions or by shifting your allocation back and forth among stocks, bonds, and money-market funds. The beauty of dollar-cost averaging is that it restrains you from pouring in too much money when the market is near a top and you're feeling euphoric, yet it forces you to keep contributing when the market is falling and you're tempted to bail out. Luckily, most people are either sensible or lazy enough to stand fast. In 1999, the most recent year for which Fidelity Investments has data, there was almost no overlap between days of high stock-market volatility and days with lots of activity in 401(k) accounts.
It's equally important to know when not to use dollar-cost averaging. If you suddenly have a large sum of money to invest--an inheritance, a bonus, or a divorce settlement, for instance--you may be better off putting it all to work in the market at once. That's because stocks go up more often than they go down. So, someone who dribbles a big sum into the market a little bit at a time will tend to come out behind someone who invests the same amount right away. Says Carl Camp, president of Eclectic Associates, a financial planner in Fullerton, Calif.: "Studies indicate the stock market goes up 70% of the time. Therefore, [dollar-cost averaging a lump sum] will be wrong 70% of the time."
Camp says he and others do advise the go-slow approach when they're worried about the shock a client would suffer from an early loss of principal. Jamie Milne, a planner in Barre, Vt., says he often deals with people such as recent widows who have never invested in the stock market. "I generally find that the best thing for them to do at first is nothing or at least start very slowly."
Meanwhile, don't kid yourself that dollar-cost averaging will protect you from the ups and downs of the market. Armstrong, the Miami financial planner, says the strategy won't shield investors from the risk of investments that fluctuate a lot. To illustrate the point, he created a computer program with 1,000 virtual investors, each investing $1,000 a year for 50 years in securities that produce a collective return of 10% a year.
With zero volatility, each investor ends up with the same sum at the end, about $1.3 million. But if volatility is high, as it is with individual tech stocks, the outcomes will be widely dispersed. Let's say volatility is 30%--meaning there's only a two-thirds chance that an investor's annual return will fall within 30 percentage points of the overall return of 10%. In that case, the bottom 500 of the 1,000 will earn just $413,000 or less. Only 220 of them will manage to earn $1.3 million (table). The average return remains $1.3 million only because a few huge winners offset the preponderance of losers.
Armstrong's imaginary example stacks the deck against volatile stocks by unrealistically assigning them the same (low) return as stable stocks. But the point remains that dollar-cost averaging doesn't magically smooth out volatility. If you're worried about the risk of owning stocks, the smarter approach is to make sure you're well-diversified. If you still don't feel comfortable putting all your lump sum in the market, simply put in what you want and hold back the rest--permanently. After all, going too far slowly is no better than going too far fast.
A good and lesser-known use of dollar-cost averaging is in selling stocks. People who need to liquidate their portfolios--say, for retirement--can spare themselves the anxiety of trying to time the market by arranging to sell a certain dollar amount of shares on a regular basis. Dollar-cost averaging can also be good for exercising stock options. If risk is no concern, then the best time to exercise options is at the last possible moment, so you can squeeze out the last bit of likely upside. But few of us are that blasé about the possibility of a last-minute wipeout. You can lock in gains by setting up a schedule for options exercise. Heather Seiche of Komack Management Services in Natick, Mass., says that for top executives, an options-exercise schedule that is approved by corporate attorneys can remove the impression that they're selling based on negative inside information.
Dollar-cost averaging does complicate the calculation of capital gains when you sell stocks that you've been accumulating in a taxable account, because each small purchase has its own cost basis. Your broker will provide you with an average cost basis. Or you can track each lot you buy, selling the ones that give you the greatest tax advantage.
In the same way that index funds are good for people who can't pick stocks, dollar-cost averaging works for people who can't time market swings. Which, come to think of it, is just about all of us.
By Peter Coy
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