NEW YORK (CNN/Money) -
I understand the concept and advantages of dollar-cost averaging for buying stocks or stock mutual funds. But does the theory hold true for bonds and bond funds as well?
- Ila Mehta, New York, N.Y.
This may surprise you, but I'm not a big fan of dollar-cost averaging. Actually, let me amend that. I don't often favor true dollar-cost averaging, though I do like a different strategy that many people erroneously call dollar-cost averaging. Confused? I don't blame you.
Before we go any further, let me define what dollar-cost averaging really is -- and what it isn't.
Let's assume you decide to invest $100 a month in stock funds and $100 a month in bond funds, each and every month regardless of what the market is doing. Is that dollar-cost averaging? I would say no.
That's just systematic investing, a strategy most of us engage in for no other reason than that's the way we get access to our investable cash. We save a bit out of our paycheck each week or month and then invest it in stocks or stock funds or bonds or bond funds. Or, in the case of a 401(k), we have our employer deduct our contribution and invest it in our plan.
I consider this an excellent way to build wealth over the long term because it takes the guesswork and emotion out of investing. That's much better than the vain exercise of trying to guess whether any given moment is a "good" or "bad" time to be putting money into the market.
A different way to reduce risk
Now let's try a different scenario. Assume you just inherited $12,000 from your dear departed Aunt Tilly. You want to invest half of it in the stock market and half in the bond market, but you're not sure how to do that. Instead of investing all your money at once, you put it in gradually, say, $1,000 a month split equally between stocks and bonds over the next 12 months.
Now that is true dollar-cost averaging. You've got a lump sum of cash in hand and you consciously decide to average it in over a specific period rather than invest it all at once. The idea is to lower the risk that you'll invest everything at an inopportune time (i.e., just before the stock and/or bond markets sink).
Is dollar-cost averaging a good idea in this case? Well, I wouldn't say you're going to do major damage to yourself by following this strategy. But it's not a particularly efficient way to reduce risk.
Is it a good idea?
If you're a serious investor, you probably have built a diversified portfolio with a mix of stocks and bonds that reflects your time horizon (how long you plan to keep your money invested) and your appetite for risk (how much you can tolerate your portfolio's value swinging up and down).
For example, if you're investing for a long-term goal like retirement, you might have, say, 70 percent of your money in stocks or stock funds and 30 percent in bonds or bond funds. If you're investing for a shorter-term goal, you'll have less in stocks and more in bonds. If you haven't created such a diversified portfolio with a mix of assets, I recommend you check out our Asset Allocator.
Let's say for argument's sake that the appropriate mix for you is 70 percent stocks and 30 percent bonds. What should you do with that money dear Aunt Tilly left? Well, one choice is to dollar-cost average by moving $500 a month into stock funds and $500 a month into bond funds over the next year until all your money is invested.
Consider that for a minute. When you parcel out the $12,000 in a year's worth of monthly increments, it means you're keeping a large amount of it in cash for most of the time. In effect, you're saying you want a more conservative blend than the 70-30 mix.
This makes no sense if you've really thought about your stocks-bonds mix and you're really convinced that 70-30, or whatever, is right for you. After all, if you've figured that a 70-30 mix of stocks and bonds represents the best balance of risk-reward for you, then you want to maintain that mix as much as possible.
Instead of parceling out Aunt Tilly's twelve grand over 12 months, you're better off investing the money all at once, in the same proportion as your stocks-bonds mix. In this case, that would mean $8,400 in stocks and $3,600 in bonds. After all, if you believe a 70-30 mix of stocks and bonds makes sense given your goals and risk tolerance, then there's no reason to change your portfolio's proportions just because you're adding new money.
(As a practical matter, of course, your 70-30 mix, or any mix, will move out of balance as some parts of your portfolio do better than others. In that case, you may want to invest your new money in a way that brings you closer to your target stocks-bonds allocation.)
The market is the key
I'm not saying that my method will necessarily lead to a higher return on your money. That will depend on what course the stock and bond markets take. If the stock market retreats during the next 12 months, then you would be better off putting a little bit into stocks each month rather than investing it all at once. If, on the other hand, the stock market takes off, you would be better off having more of your stock money invested early on.
The point, of course, is that we don't know what the markets will do. Parceling out our money a bit at a time is one way to protect ourselves against this uncertainty. But if you've built a diversified portfolio, then you've already hedged against that risk. Spreading your investment over time could actually work against your asset allocation strategy.
Rather than spend time agonizing over whether to put your money in gradually and over what time period, I'd recommend settling on a portfolio mix that makes sense for you given your goals and risk tolerance. Then, invest new money in a way that's consistent with your mix.
Throw in some disciplined systematic investing on top of that strategy, and you have a good shot at building some real wealth over your lifetime.
-- Walter Updegrave is a senior editor at MONEY Magazine and is the author of "Investing for the Financially Challenged." He can be seen regularly Monday mornings at 7:40 a.m. ET on CNNfn.