Dollar-Cost Averaging Still the Best Strategy
You inherit $5,000 bucks and finally are in a position to start investing. Do you invest it all at once or do you invest a small percentage each month until it's gone? For years, conventional wisdom argued in favor of the latter. That way, you'd buy shares when they were up, down and in between, yielding a reasonable average cost. Seems like a much more preferable alternative than investing all your money and risking the possibility that the market may tank - reducing your investment by 10 percent or more.
But recent studies have called conventional wisdom into doubt. If you invest your money all at once, they argue, you would likely do better in the long run even with a big downturn than by gradually investing your money, a technique known as dollar-cost averaging.
Using dollar cost averaging, an investor typically would invest the above $5,000 over, say, a year in equal monthly amounts. But two Wright State University professors found that between 1926 and 1991, if you invested your money all at once, you would have done better 65 percent of the time.
In a way that makes sense. Stocks generally do better over time, so if you get in early and stay there, you're likely to do just fine.
But what about 35 percent of the time when that wasn't the case, like the crash of 1929, or the dismal years of the early 1970s? Your investment would have dropped 10 percent to who knows what in but a few short years.
The whole point of dollar-cost averaging isn't to make a killing; its to reduce risk and to allow you to sleep better at night - at least for the period that you're are gradually putting money into stocks.
Another benefit of dollar-cost averaging is that it makes you a disciplined and consistent investor. Nearly all financial planners argue that it's far better to invest a little each month than to invest sporadically. People who promise themselves that they will skip their vacation next year and invest the money for the kids' education rarely have the discipline to follow up.
Dollar-cost averaging isn't so important when there's only a few thousand dollars. After all, if you invest, say $3,000, and it drops 10 percent, it's not going to ruin many people. But what about when you get a big lump sum distribution when you retire, or if you inherit quite a bit of dough? That's truly when dollar-cost averaging comes in handy.
Bottom line: there's no excuse not to invest by dollar-cost averaging. Nearly all mutual funds allow you to have a certain portion of your paycheck allocated to buying more shares of your funds. All you have to do is sit back and watch them grow with each monthly statement.
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