NEW YORK (CNNfn) - Maybe you just inherited a big chunk of money you'd like to invest but you're worried about stock volatility. Or maybe you're like most people and you just don't have a lot of cash lying around to put in the market.|
Either way, a strategy known as dollar-cost averaging could be a way for you to get your dollars working on Wall Street with less risk and cost.
Dollar-cost averaging is the practice of regularly investing a fixed sum regardless of which way the stock market is moving, according to Dee Lee, author of† "The Complete Idiot's Guide to 401(k) Plans."
"Some people get frightened when the market drops after they put money in, so the client feels good doing dollar-cost averaging spread over the year," Lee said.
When prices are high, your money buys fewer shares, and when prices are low, your money buys more, Lee says. But over time, you'll will probably wind up with more shares at lower prices than if you bought them all at once. It reduces your average share cost and spreads your investment risk over time.
In fact, many people are already doing a form of dollar-cost averaging in their 401(k) plans by making regular, fixed contributions.
How does it work?
Let's say you'd like to invest $2,000 in a mutual fund.
Using dollar-cost averaging, you could plan to make five monthly payments of $400 each, buying shares at both highs and lows.
You might start buying some shares at $10 each, and later buy some shares for as little as $5 each. The average cost would be $7.69.
But if you had invested all of your money at the beginning, your average share price would be $10.
And by putting money in a little at a time, you don't have to worry about trying to figure out if the market is going up or down.
"No one is really that good at reading the crystal ball," said Diane Rolfsmeyer, a certified financial planner from Lincoln, Neb. "(Dollar-cost averaging) puts in place a pattern of purchasing behavior that in time will average out to be good."
- You invest a fixed amount on a regular basis, regardless of the current market trends.
- You buy more shares when the price is low and fewer shares when the price is high.
- It does not assure a profit or protect against a loss in a declining market.
- You must continue to purchase shares both in market ups and downs for the strategy to be effective.
Source: Fidelity Investments
When using dollar-cost averaging, planners suggest you park the remaining future contributions in a short-term investment like a money market account, a CD or other cash equivalent that's earning close to 8 percent.
"You want to be sure the money isn't idle," Rolfsmeyer said.
A different approach for less volatile stocks
Investors should keep in mind, however, that dollar-cost averaging doesn't guarantee a profit if prices keep falling. In cases when prices are rising steadily over time, the opposite strategy -- lump sum investing -- will succeed.
"If someone walked in today with $100,000, I would say 'Go for it.' Other times I would say the market's at its peak so let's put this in over some months," Lee said.
A recent analysis in the Journal of Financial Planning found that it isn't clear whether dollar-cost averaging or lump sum investing is better.
Using a complicated formula called the "Monte Carlo simulation model," authors Sarath Abeysekera and E.S. Rosenbloom found that people shouldn't use dollar-cost averaging for low-volatility stocks, but that it would be better to help reduce risk with volatile stocks.
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†"...A simple rule stating that one strategy is necessarily superior to the other would be very misleading," the authors found.
Still, dollar-cost averaging will give nervous investors something that perhaps can't be measured in monetary terms: a good night's sleep.
†"It's psychology," Lee said. "It makes people feel better."