Ways to Smooth Out Market’s Ups and Downs

When the going gets tough, investors are supposed to hang tough. But instead, when the stock market stumbles, investors tend to head for cover in droves. Just look at all the nervous selling over the past month.

For skittish types, it can make sense to follow a “dollar cost averaging” approach to mutual fund investing. That’s a highfalutin term for a fairly simple process.

It means investing a fixed amount at regular intervals, perhaps every month or every quarter, so you wind up buying shares at various prices--fewer shares when prices are high and more when they’re low.

The advantage is that it “removes the guesswork and difficulty of trying to time the market,” said Anne Patenaude, vice president of marketing with the Pioneer Funds group in Boston.

You can rest assured that you won’t be putting all your marbles into play at a market peak. “Dollar cost averaging gives you time diversification,” said John Markese, director of research for the American Assn. of Individual Investors in Chicago.

You can follow a dollar cost averaging strategy to purchase many types of assets, from gold coins to stocks. But the process works especially well with mutual funds, which routinely accept small periodic investments and will credit you with a fractional purchase of shares. Averaging is more common with equity funds rather than bond funds because of the greater volatility of the stock market.

Most mutual fund companies require initial investments ranging from $250 to $3,000 or so, with subsequent purchases of at least $50 to $250. However, Janus Funds of Denver and Twentieth Century Investors of Kansas City--two families with good track records--will accept contributions of any size for initial purchases or subsequent investments.

You can automatically buy shares in a mutual fund by taking money from your paycheck or bank account at regular intervals. There’s usually no charge for this service, other than the normal front-end sales fee if you invest in a load fund.

An alternative is to transfer cash gradually into a stock or bond fund from a money market portfolio within the same family. If you get a large chunk of cash all of a sudden--from a pension withdrawal or inheritance, for example--this can be a good way to ease into the market, says Paul Merriman, head of the Merriman Funds group in Seattle.

You don’t have to set up an automatic dollar cost averaging program. You may simply write a check each time you want to invest. However, there’s a danger in relying on your own impulses.

“When the market takes a big hit, that’s when people tend to throw in the towel,” Merriman said. To succeed with an averaging strategy, you need to keep investing through at least one full market cycle. Nobody likes to invest during bearish phases, yet that’s the time when prices are lowest.

In fact, there’s substantial evidence that a dollar cost averaging strategy can work nicely with a well-managed, well-diversified mutual fund.

American Funds Group of Los Angeles offers a worst-case illustration of dollar cost averaging. Suppose you placed $5,000 into the company’s American Mutual Fund each year from 1970 through 1989. Further imagine that you had the unlucky knack of making your investments exclusively on the worst possible day in each calendar year--such as Aug. 25, 1987, the high point before the market crashed two months later. Would you show a big loss? Hardly.

As it turns out, your total investment of $100,000 would have grown to nearly $538,000 at the end of 1989, representing a 14.3% compounded annual gain. The moral of the story: It’s more important to keep adding to your stake in a good fund than to worry about the best times to buy along the way.

Of course, dollar cost averaging assumes that equity funds will rise over the long term. That’s a pretty solid bet, considering that the stock market has declined in just 19 of the 64 years back to 1926. At any rate, it’s certainly wiser to keep plowing money into a well-diversified fund than a single stock, because you never know if a company is going down for good.

One criticism of dollar cost averaging is that it addresses just half of the investment equation--it tells you how and when to buy shares but provides no guidelines for selling. Michael E. Edleson, assistant professor of business administration at the Harvard School of Business, believes that he has found an answer.

Writing in the American Assn. of Individual Investors Journal, Edleson recommends an approach that he describes as “value averaging.” Rather than invest, say, $100 each month, you would instead follow a strategy of making your fund grow by $100 a month. In other words, you would first figure out how much your portfolio went up or down during the month, then add--or even subtract--money to make sure the overall increase amounted to $100.

For example, suppose you had $4,000 in a fund on Aug. 31 and wanted to see it grow by $100 a month, to $4,100 as of Sept. 30. Here’s how you would respond to three different scenarios:

* If a falling market during September pulled down your investment in the fund to, say, $3,900, you would add $200 to reach the $4,100 level.

* If a slowly rising market increased your stake to $4,030, you would add $70 for the month.

* If a strong rally carried you up to $4,270 during September, you would sell $170 worth of shares.

Edleson claims that his system is more profitable than regular dollar cost averaging. “It forces you to buy even more than usual when the share price goes exceptionally low,” he said. In addition, it prompts you to sell shares during rallies.

He tested the two averaging methods using his own money during a 25-month period from 1986 to 1988. Edleson wound up investing at an average cost of $4.07 a share using his system, compared to $4.85 for traditional dollar cost averaging.

Edleson admits that his approach isn’t perfect. It’s more complicated than regular dollar cost averaging, and it can force you to regularly incur capital gains taxes on shares you sell at a profit. Also, you might be subject to minimum investment or redemption restrictions, depending on the fund company.

The key point is that an averaging strategy of some type can help you come to terms with volatility. As a result, you can stay invested for the long haul, with less emotional wear and tear along the way.

HOW AN INVESTOR WOULD FARE WITH DOLLAR COST AVERAGING The following shows how an investor would have fared with a dollar cost averaging approach to investing in stocks. It assumes that the investor placed $100 a month every month from January, 1978, through December, 1989, into the T. Rowe Price New Era Fund. It also assumes that all dividends and capital gains were reinvested. The investor’s outlay during the 12-year period would have been $14,400. Below are three representative years.

Amount Account Value Change From Year Invested at Year-End Previous Year 1981 (Down Market) $1,200 $7,105 Down $20 1984 (Flat Market) $1,200 $13,840 Up $1,650 1989 (Bullish Market) $1,200 $41,016 Up $9,080