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.