Safety calls for systematic way to invest

Method: Dollar-cost averaging, one of the systems, saves the investor from making emotional mistakes.

Dollars & Sense

October 28, 2001|By Gus G. Sentementes | Gus G. Sentementes,SUN STAFF

If you regularly contribute money to a 401(k) or mutual fund, you're using a technique known as dollar-cost averaging to invest in the stock market.

For beginning investors, it's a way to join the market fray without fretting over when to jump in - you can start anytime. Although it's common among people building their long-term savings, the strategy still calls for discipline in both good and bad times.

It works basically like this: When share prices rise, your fixed dollar amount buys fewer shares; but when prices drop, those same dollars snap up more shares at a bargain. Long-term investors use the method to accumulate wealth over many years and reduce their average cost per share.

Company stock purchase plans and dividend reinvestment programs, where dividends are used to buy more shares, are two examples of similar systematic investing techniques.

"It's disciplined, and a lot of investors, frankly, need discipline," said Preston G. Athey, portfolio manager of Baltimore-based T. Rowe Price Associates Inc.'s Small-Cap Value Fund, a mutual fund that invests in companies with a market capitalization under $1 billion.

"Investor behavior shows that investors too often will buy and sell on emotion, and generally when they buy and sell on emotion, the timing is poor ... [dollar cost averaging] keeps you from making stupid decisions."

The strategy means sticking to a schedule, even when day-traders and short-term speculators head for the hills.

"It depends on your appetite for risk," said Michael Fu, a professor of management science at the Robert H. Smith School of Business at the University of Maryland, College Park. "The main reason for doing [dollar cost averaging] is to reduce having to time things."

Here's a hypothetical example: Say you choose to invest $200 per month in a mutual fund that sells at $10 per share when you begin. The first month, you'll buy 20 shares. In the second month, if the share price drops to $8, you'll buy 25 shares with another $200. The price stays the same in the third month, and you pick up another 25 shares. In the fourth month, the price jumps back to $10 and you acquire 20 shares. In the fifth month, the share price suddenly zooms to $20 - you pick up 10 shares.

After five months, you will have invested $1,000 for a total 100 shares. Your average share cost is $10, while the average price paid per share was $11.20. The benefit, experts say, is that it helps lower the average price paid per share across an entire portfolio.

But there are some things to watch for when using this technique, financial experts say. For example, as income level rises, investors may wish to increase their regular contribution to keep pace with their earnings. And if you use the technique to invest in specific stocks, make sure you keep your investment portfolio diversified, experts cautioned.

Also, an investor with a large lump sum to invest - say, $50,000 - will likely have better returns if he or she invests in the market right away, according to some financial planning experts.

Most people reap the benefits of dollar cost averaging through their long-term savings plans, said Kevin Condon, director of financial planning for Baltimore-Washington Financial Advisors Inc. in Ellicott City.

"There's been some good [statistical] work that shows that dollar cost averaging will put you ahead in all kinds of markets," Condon said.

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