How Dollar-Cost Averaging Can Smooth Your Returns

By David Kathman, CFA, Morningstar

Even though U.S. stocks have made some impressive headway in recent weeks and have certainly rebounded significantly from the lows they hit in March 2009, many investors are still feeling scarred from the past decade's volatility. Some investors have retreated to bonds or left large sums of money sitting fallow in cash; others have ventured into gold as a means of diversifying away from core equity and bond investments.

If you've stayed invested in the stock market, either directly or through mutual funds, it's natural to be looking for ways to smooth out your portfolio's returns going forward. And if you've retreated to the sidelines, you may be wondering if now is a good time to get back in. One way for both sets of investors to achieve peace of mind is through dollar-cost averaging, a simple, time-tested method for controlling risk over time.

How It Works
The basic idea behind dollar-cost averaging is straightforward; the term simply refers to investing money in equal amounts at regular intervals. One way to do this is with a lump sum that you'd prefer to invest gradually--for example, by taking $1,000 and investing $100 each month for 10 months. Or you can dollar-cost average on an open-ended basis by investing, say, $100 out of your paycheck every month. The latter is the most common method; in fact, if you have a 401(k) or similar defined-contribution retirement plan, you've probably already been dollar-cost averaging in this way.

One reason dollar-cost averaging is so attractive is that it forces you to invest no matter what the market is doing, thus helping to avoid the poor decisions most people make when trying to time the market. When the stock market is going down, lots of people become fearful and reluctant to put money into stocks. That may help avoid some losses in the short term, but when markets eventually start going back up, someone who has avoided stocks will lose out on the gains. Those who invest a fixed dollar amount every month, on the other hand, will be in a much better position to benefit when the market bounces back, and meanwhile they'll often be buying stocks at bargain prices.

In a bull market, the opposite is true: dollar-cost averaging prevents you from getting carried away and putting too much money in stocks that may be too expensive and poised for a fall. In the raging bull market of the late 1990s, lots of otherwise rational people were swept up in the mania and loaded up on stocks trading at exorbitant prices; when the market crashed, many of those investors got badly burned. Investors who dollar-cost averaged into a stock portfolio missed out on some of the upside at the height of the bubble, but they were generally in much better shape when the market went south.

Why It's a Good Idea
As these examples show, dollar-cost averaging can help investors limit losses, while also instilling a sense of investment discipline and ensuring that you're buying shares at ever-lower prices in down markets. Numerous studies have confirmed that it also results in better returns than strategies that involve moving in and out of the market.

For example, a Fidelity study looked at how several different strategies would have performed from January 2000 to January 2004, a period that included the dotcom bust and the start of the subsequent recovery. The study found that the best results came from steadily investing $500 every month into an S&P 500 stock portfolio. This dollar-cost averaging strategy even outperformed a "bear-market dodger" strategy that started putting all its new money into cash in April 2000, at the height of the market bubble. Strategies that shifted into cash after the market had declined 20% (bear-market refugee) or at the market bottom (doomsday capitulator) did even worse.

Certainly it's possible in retrospect to identify plenty of times over the past few years, such as the summer of 2008, when you would have been better off moving temporarily into cash. Such times are only obvious in retrospect, though. Somebody who moved into cash in early March of 2009, when market sentiment was arguably worse than summer 2008, would have missed the strong recovery that ensued.

The point of dollar-cost averaging is that it's impossible to predict the market's ups and downs accurately, and most investors who try to do so end up hurting their returns.

How to Do It
If you decide that dollar-cost averaging is a good idea, there are a number of ways to implement such a plan. If you're really disciplined, you can set one up on your own, figuring out how much you want to invest and then sending in a check each month. However, most people find it easier to stick to a dollar-cost averaging plan that's set up to work automatically. As noted above, most 401(k)'s and similar retirement plans, such as 403(b)s, involve a form of dollar-cost averaging, as they take a fixed percentage of your paycheck and invest it in a prearranged group of funds or other investments. It's best not to mess around too much with the percentage you contribute to your 401(k). The advantages of dollar-cost averaging will be diluted or lost if you change this percentage in response to market conditions, for example, by cutting back your contribution when the market is going down.

Many mutual funds also have automatic investment plans that allow you to invest a fixed amount automatically every month. In many cases, the minimum initial investment needed to get into these funds is much lower if you set up an automatic investment plan; this makes such plans especially attractive for kids or recent college graduates who want to invest but don't have a lot of money up front.