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How to Time Your Buys

Dollar-cost averaging -- the practice of making an investment in regular intervals over an extended period of time, rather than all at once -- is a favorite recommendation of full-service brokers, an occasional subject of lively debate on the Fool's message boards, and a technique that has found some favor among Fool writers. Yet there's a growing body of academic research that claims to show that dollar-cost averaging is largely ineffective in practice, and may even be harmful to your financial well-being under some circumstances. What's a Fool to do?

The joy of statistics
Advocates of dollar-cost averaging (DCA) say that slowly investing a lump sum in small pieces over an extended period of time lowers your average share cost, your investment risk, and maybe even your chance of being abducted by space aliens. To bolster their case, they present charts showing a hypothetical investment (say of $40,000) in a stock with a made-up price history (say $50 to $30 to $20 to $60 over the course of four quarters), and then demonstrate that making investments of $10,000 in each of those four periods would have resulted in an average share price of $33.33 instead of the $50 you would have spent if you had invested your $40,000 in one lump sum at the beginning.

Of course, anything can be proven with made-up data. The problem is that real-world stock prices (mostly) don't move like that. For any given randomly selected period of time, the market is about twice as likely to have gone up as down. During bull-market periods -- and a glance at any historical chart will show you that the vast majority of the last 80 years or so were bull-market years -- that hypothetical stock's price history might instead look something like $40, $44, $49, $56 over four quarters, with maybe a quick three-week down-and-back-up correction in there somewhere. And unless you were lucky enough to buy at the bottom of that correction, you would have done best making your full investment at the beginning -- in my example.

Out in the real world
Last year, Texas A&M University finance professor John G. Greenhut looked at various academic studies of DCA, hoping to be able to explain why the strategy continued to be popular despite a growing body of evidence that it didn't work -- and why a few studies had, contrary to the majority of the research, found DCA to be a successful approach on occasion. His analysis is complicated (as you'll see if you click that link), but the gist of his conclusion is that lump-sum investing (abbreviated as "LS" in his article) is the better approach most of the time -- i.e., when the market is trending upward -- and that illustrations showing DCA at an advantage almost always use hypothetical stock-price patterns that don't match real trends. Or, as he put it, "The price variations that would be expected for fundamentally valued stocks is precisely the pattern that negates the advantage DCA commonly has been illustrated to hold." So if you want to buy real stocks, the research says, you're almost always better off (and almost never worse off) buying them with a single lump-sum investment.

The upshot
So what does this mean for us? First, let's be clear: there's nothing wrong with periodic investing in and of itself. Whether you're investing in blue chips like Coca-Cola (NYSE: KO  ) , 3M (NYSE: MMM  ) , or Johnson & Johnson (NYSE: JNJ  ) via a dividend reinvestment plan, contributing to your 401(k) or 403(b) plan, or just looking to put $250 out of every paycheck into a mutual fund, those are all excellent ways to build investment positions (and wealth) out of your cash flow over time. But if you're investing a large lump sum, such as an inheritance or a 401(k) rollover, be wary of those who advise you to use DCA to lower your average per-share price -- especially if they're full-service brokers, who would no doubt be pleased to accept your commission payments on several trades rather than one. Unless you're investing at the very beginning of a long bear market, which is almost impossible to determine except in retrospect, you will usually do better in the long run if you get that windfall fully invested in the stock market right away -- even if you just park the balance in an index fund while you start researching promising small-cap stocks. Your neighbor the broker might not thank you, but your future self will.

Do you want to find out which unheralded small-cap stocks Tom Gardner and theMotley Fool Hidden Gems crew have identified as the blue chips of the future? Click here to get full access -- free for the next 30 days.

Fool contributor John Rosevear does not own any of the stocks mentioned in this article. Coca-Cola and 3M are Inside Value recommendations, while Johnson & Johnson is an Income Investor pick. The Motley Fool has a disclosure policy.


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John Rosevear
TMFMarlowe

John Rosevear is the senior auto specialist for Fool.com. John has been writing about the auto business and investing for over 20 years, and for The Motley Fool since 2007.

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