The limitations of dollar-cost averaging

STAYING AHEAD

November 14, 1993|By JANE BRYANT QUINN | JANE BRYANT QUINN,1993, Washington Post Writers Group

New York -- Are you "dollar-cost averaging" your stock investments? That's what many experts advise. But just when you thought you had found the path to investment wisdom, a study says that, sometimes, it's the wrong way to go.

You dollar-cost average when you invest a fixed sum regularly -- for example, once a month. Each purchase is made at a different price -- sometimes more, sometimes less than you paid before. This gives you an average price over time. You use this system automatically when you're on a payroll-deduction plan, and it works just fine. The question is whether dollar-cost averaging is equally wise when you want to invest a lump sum.

Say you want to buy stock mutual funds with the proceeds of a certificate of deposit, an inheritance or a payout from a retirement plan. To dollar-cost average, you would stash the money in a money-market account, then start buying fund shares in bite-size pieces, once a month. It might take you 12 months to become fully invested, and you would have avoided a serious loss if the market dropped.

As an example, assume you had put $12,000 in Vanguard's Index Trust/500 Portfolio (which follows Standard & Poor's 500-stock average) on Oct. 1, 1987, just before the crash. One year later, your nest egg would have been worth only $10,468 (including dividends). Had you dollar-cost averaged that Vanguard investment -- buying $1,000 worth of shares on Oct. 1 and on the first day of each subsequent month -- you would have had $12,661 one year later, plus the interest your money earned while it was waiting to be invested.

In theory, there's a second advantage to dollar-cost averaging. When you buy in fixed-dollar amounts each month, you get more shares when the price is low and fewer shares when the price is high. If the market dips and then rises, you wind up with a below-average cost per share, which potentially yields a better profit when you sell.

But does it really? Not in most cases, say Professors Richard Williams and Peter Bacon of Wright State University in Dayton, Ohio. Usually, stocks produce better returns than bank deposits or money-market funds. And the market rises more often than it falls. So if you want to be in stocks, the odds are that you will do better by investing as fast as possible.

The professors studied two investment methods. Investor A put a lump sum into stocks at the start of each year; Investor B put money into Treasury bills and fed it into stocks in 12 equal monthly installments. At the end of each year, they compared returns.

In most cases, the lump-sum investor came out ahead. For example, from 1970 through 1991 (which covers both the no-go '70s and go-go '80s), the lump-sum strategy beat a dollar-cost-averaging strategy 60 percent of the time. Going back to 1950, it won 66 percent of the time. And on average, total returns were significantly better.

Lump-sum investing almost always wins in years when the market rises. So you're making a market-timing bet, knowing that the odds are with you. You stand a better chance of earning higher returns than if you stretched your investment out.

On the other hand, dollar-cost averaging lowers your risk. That's why many money managers use it, even though the odds favor lump sums. Wesley McCain, chairman of Towneley Capital Management in New York City, says that when 60-year-old retirees give a manager the proceeds of their lifetime 401(k) plans, "they're saying, 'Here it is, don't lose it.' And I never know when it's going to be October 1987."

McCain's advice for investors who would rather play it cautiously even at the risk of earning somewhat less: Take one year to invest a lump sum in stock mutual funds. For bond funds, he suggests four to five months. He'll invest rapidly, however, if the stock market drops.

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