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Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail

Ask the Expert: Why Is Dollar-Cost Averaging Good For My Portfolio?

Each week, one of our investing experts answers a reader's question in our InvestingAnswers' Q&A column. Send us yours at editors@investinganswers.com. (Note: We will not respond to requests for stock picks.)

Investors tend to want to rapidly enhance their exposure to the stock market when it is rallying, and they're in a hurry to dump their stocks when the market is falling. Today's question helps shed light on a much more patient and pragmatic way to build a portfolio.

Question: I've been hearing a lot about dollar-cost averaging. What is it, and should I be using it?
--Cecilia H., New Haven, CT

The Investing Answer: Well, it's a very simple but under-utilized way to build a portfolio, and it carries several advantages.  It's certainly a good practice to help you build discipline and ignore your emotions when it comes to the stock market.

Dollar-cost averaging involves investing the same amount of money into stocks (and funds) each month or quarter. You can determine the right amount for your needs, whether it's $100 a month, $1,000 a month or more.

That depends on how much money you have to invest and your age. If you're just starting out in the market and are in your 20's or 30's, a modest sum is the way to go, as you may still be paying off student loans or need to support a young, growing family. If you got off to a late start and have only begun investing in your 40s or 50s, then it may be wiser to commit bigger sums of money to the market each period.

Still, you might wonder: "If I have a pile of cash to put into the market, why not just become fully invested as quickly as possible?"

Well, the 1990s serve as a great example. In 1997 and 1998, many people still had scant exposure to stocks. But by 1999, there was an absolute frenzy to quickly get invested in a very impressive bull market. You can see the stampede into stocks just by looking at what happened to the Nasdaq Composite index, which was home to high-growth tech stocks.
 
Though billions poured out of bank accounts and into the stock market in a very short time, investors would suffer a massive headache. The Nasdaq peaked at around 5,000 in March 2000 but, by October 2002, had plunged 75% to just 1,250.

Yet more patient investors, willing to use dollar-cost averaging, would have held much of their cash in reserve and had the chance to buy stocks early in the past decade. Meanwhile, the most aggressive investors who poured all of their money into tech stocks at the market peak had no money left to invest, and many of them ended up shunning stocks for much of the next decade.

In the example I just noted, it's fair to question whether it was wise to keep buying stocks in 2000, 2001 and 2002, if they were steadily falling. After all, you could have just waited until tech stocks bottomed in 2002 and then started buying. Yet as many experienced investors will tell you, "You can't time the market."

We have no way of knowing where the market will be in six or 12 months, and if you're bullish on stocks simply because they have performed well in the recent past, then you are likely to get burned. And if you are bearish on stocks because they have fared poorly recently, then you may be mistakenly missing out on solid buying opportunities.

Warren Buffett is perhaps the most high-profile practitioner of dollar-cost averaging. He tends to buy and sell stocks every quarter at a steady and predictable pace, rarely changing the volume of his buys and sells from quarter to quarter. Compare that with many famous hedge fund managers who tend to make bold, rapid bets on the market. They can look like geniuses in some years, but they can also lose big sums of money if those bold bets are wrong.

(Buffett does make one exception: He has been a very aggressive buyer of stocks when they are sharply plunging, as he notes that you can make big profits when the crowd is fleeing. In August 2011, with the markets in freefall, he noted that it was his most active buying time in his history. Otherwise, he's the king of dollar-cost averaging).

So when is it time to sell? As investors approach retirement, they tend to stop buying stocks and prepare to start selling their holdings to raise cash for lifestyle needs. And when it comes time to sell, dollar-cost averaging isn't necessarily the prudent course. Financial planners suggest you withdraw the money you need for the next few years, but otherwise leave funds in the market, so they can continue to appreciate over time.
 
One final note: Investors can be their own worst enemy. They often aggressively buy stocks during robust market rallies, which can set the stage for big losses if they arrive at the party too late. Instead, use dollar-cost averaging so you can ignore the market noise and stick with a savvy long-term game plan.

P.S.: Ready to dive into the market, but unsure where to start? Writing in plain English and doing the work for you, StreetAuthority's Amy Calistri has made picking stocks easier for readers of Stock of the Month. Let her tell you about her strategy in "How to Beat the Stock Market... In Just 12 Minutes per Month." Go here to learn more.