Managing Money : For Long Haul, Dollar-Cost Averaging Takes Emotion Out of Investing

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Suppose you saw an ad like that. Would you respond? If so, you might be game for “dollar-cost averaging,” an investment approach widely used with mutual funds.

Dollar-cost averaging is a tried-and-true way to invest long term. In a typical plan, you would sock away a set amount of cash at regular intervals--say $100 every month or quarter.

Averaging helps you wring emotions from the investment process because you’re putting away relatively small amounts gradually and purchasing shares at various prices.

“You can invest without worrying whether this is the right time to buy,” says Howard Schneider, a spokesman for the mutual fund group run by the American Assn. of Retired Persons.

In fact, when the stock or bond markets decline, you’re able to purchase more shares at cheaper prices. So even when Wall Street drops 120 points, as it did Nov. 15, dollar-cost averagers get a consolation prize.

“By investing on a regular basis, you buy more shares in a declining market and fewer shares when the market’s rising,” says Carolyn Archer, vice president of marketing for the United Services fund group in San Antonio. “This protects people who tend to buy at high points.”

You can use dollar-cost averaging to purchase individual stocks or bonds, but it works especially well for mutual funds. Because funds hold a diversified mix of securities, they usually bounce back from declines when markets recover. You can’t say the same about an individual stock or bond, which could become worthless if the company goes bust.

Most mutual fund companies offer some type of automatic investing program, although they might not call it dollar-cost averaging. Many lower their investment minimums for people willing to put money away on a schedule.

For example, the AARP waives its normal $500 up-front minimum for people who agree to sock away at least that much during a year. United Services requires just $100 initially and $20 a month after that, compared to $1,000 normally. Two other companies, the Janus Group of Denver and Twentieth Century Investors of Kansas City, Mo., also have low- or no-minimum programs for people who use dollar-cost averaging.

In terms of simplicity, it’s hard to beat a dollar-cost averaging program. You need only fill out the required page or two of forms, designating how much and how often you want to invest and from which checking or savings account you want the money withdrawn. The fund company debits your account for the indicated amount at the specified times.

“With dollar-cost averaging, people have to make an investment decision only once,” says Michael Hines, vice president of marketing for Fidelity Investments in Boston. “The real benefit is simplification rather than a strategy to outfox the market.”

Fund companies will let you change the amount and frequency of your contributions whenever you want. Naturally, you can stop making investments or even withdraw from most programs.

Because of the inherent volatility of the stock market, dollar-cost averaging works better with equity funds than bond portfolios, experts say. Michael Edleson, a finance professor at Harvard University, suggests using a fund that stays fully invested in stocks, such as one that tracks the Standard & Poor’s 500 index. That way, you can be sure of buying more shares at lower prices and fewer at higher prices, as your fund will move in line with the market.

However, if you have a large chunk of money to invest and want to ease in gradually, consider putting everything into a money market fund first, then dollar-cost averaging into a stock fund run by the same group. In so doing, you don’t have to worry about risking the entire amount at once.

Success with dollar-cost averaging rests on the notion that the stock market will appreciate over time, which historically has been the case. The benchmark Standard & Poor’s 500 average has risen 46 of the 66 years dating to 1926, reports Ibbotson Associates, a Chicago research outfit. Even more encouraging for long-term investors, the S&P; 500 has gained ground in 55 of the 57 10-year periods over that stretch.

If you want to try to improve on dollar-cost averaging, take what Edleson calls a “value-averaging” approach. This way, rather than investing, say, $100 a month, you would try to make your account grow by $100 each month.

Consequently, during down months in the market, you might wind up investing well more than $200, thereby buying even more shares when prices are low. During good months, you would invest less than $200 or you might sell some shares. Value averaging thus offers a guideline for deciding when and how much to sell, which dollar-cost averaging doesn’t address.

Edleson, author of a book on value averaging, says the strategy beats dollar-cost averaging about 90% of the time.

As for drawbacks, value averaging requires more work and will probably result in more taxable transactions. Plus, your fund company might limit the number of times you can sell during the year or restrict trades below a certain dollar amount.

Whether you try dollar-cost or value averaging, the point is to get started on a plan that will give you the emotional discipline to hang tough for the long haul. “Any kind of plan,” says Edleson, “is better than no plan at all.”

A Little Bit At a Time

With dollar-cost averaging, you invest a fixed amount of money on a predetermined schedule, such as $100 every month. The idea is to buy fewer mutual fund shares when prices are high and more when they’re low. The approach assumes that the stock market will rise over time, as it historically has. Here’s how a dollar-cost averaging strategy might fare under two scenarios:

Falling Market

During falling markets, the current account value tends to stay below the total amount invested, resulting in a temporary paper loss, yet more shares are purchased.

Amount Price/ Shares Total Total Account Month Invested Share Bought Shares Invested Value 1 $100 $10.00 10.0 10.0 $100 $100 2 $100 $12.50 8.0 18.0 $200 $225 3 $100 $10.00 10.0 28.0 $300 $280 4 $100 $8.00 12.5 40.5 $400 $324

Rising Market

During rising markets, the account value tends to exceed the amount invested, producing a paper gain. However, fewer shares are purchased.

Amount Price/ Shares Total Total Account Month Invested Share Bought Shares Invested Value 1 $100 $10.00 10.0 10.0 $100 $100.00 2 $100 $8.00 12.5 22.5 $200 $180.00 3 $100 $10.00 10.0 32.5 $300 $325.00 4 $100 $12.50 8.0 40.5 $400 $506.25