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This Wealth-Maker Is Alive and Well

There's a simple method that millions of investors have used to build up wealth over the long run. It makes intuitive sense, and it's easy to execute. But some people have attacked this simple strategy as producing less-than-perfect results.

The strategy is known as dollar-cost averaging, and it's something that most people do without even ever thinking about it. Given the criticism it has received, however, is dollar-cost averaging the wrong way to save for retirement and your other long-term financial goals?

Below, I'll take a closer look at that question. First, though, let's examine exactly what dollar-cost averaging means and why it makes sense for many investors.

The innate appeal of dollar-cost averaging
The idea behind dollar-cost averaging couldn't be simpler. Here's how it works: Every month, invest the same dollar amount in a stock or mutual fund. You can use the strategy either with a starting lump sum of cash or as you receive income from paychecks or other sources.

The strategy is appealing for a couple of reasons. First, the strategy naturally takes advantage of changing prices. When share prices are low, your investment buys more shares on the cheap. Conversely, your fixed dollar amount buys fewer shares when their price is higher. On the whole, this prevents you from buying high -- and if share prices bounce up and down a lot, you can end up with more shares this way than you would by making a bigger up-front purchase.

Second, dollar-cost averaging makes nervous investors feel more comfortable. If you've kept a lot of money in cash and then decide to get it all back into the market at one fell swoop at what proves to be exactly the wrong time, you may panic and sell everything after a drop. But if you invest a bit at a time, then you're more likely to weather the inevitable storms or even see them as buying opportunities.

What's the problem?
Despite the intuitive appeal of dollar-cost averaging, the method has come under fire for producing subpar results. Research that looked at the method from 1926 to 2010 found that you would've been better off 70% of the time if you invested a lump sum all at once rather than breaking it up into 12 monthly dollar-cost-averaged chunks. Over 20-year periods, dollar-cost averaging cost you about 2 percentage points of annual return versus getting everything invested all at once.

The results of that research clearly follow from the fact that stocks tend to outperform cash, and in general, the faster you get your money into stocks, the longer you'll benefit from their better returns. But consider these counterarguments:

Research that focuses on broad-market indexes undervalues dollar-cost averaging compared to individual stocks, because higher volatility can bring more favorable results from the method. For instance, the casino industry has seen huge price swings among its stocks as investors react to changing conditions in Las Vegas, Macau, and elsewhere throughout the world. As a result, dollar-cost averaging in Las Vegas Sands (NYSE: LVS  ) and MGM Resorts (NYSE: MGM  ) would potentially give you a greater advantage than doing so with an S&P 500 index fund.

Reinvesting dividends can act to supplement an explicit dollar-cost averaging method. So for instance, using high-yielding master limited partnership Linn Energy (Nasdaq: LINE  ) or royalty trust BP Prudhoe Bay (NYSE: BPT  ) not only as dollar-cost averaging candidates but also to reinvest dividends lets you benefit twice from the idea of buying more shares when prices are low than when they're high. Even a dividend-oriented ETF such as SPDR S&P Dividend (NYSE: SDY  ) can give you double benefits from dollar-cost averaging.

Perhaps more realistically, getting investors to put a big lump sum to work all at once is asking for procrastination problems. It's a lot easier to overcome the reluctance to invest by doing it a little at a time rather than in one big buy -- even if it might lead to slightly lower returns.

Do what it takes
Saving up a little at a time and letting it build up over the years is a proven method of creating long-term wealth. Dollar-cost averaging plays a big part in that -- and it'll continue to do so well into the future.

Dollar-cost averaging is only as good as the investments you pick, though. Get some ideas from The Motley Fool's latest special report on retirement, where you'll find three promising stock picks for long-term investors. It's free, but don't wait; get your free report today while it's still available.

Fool contributor Dan Caplinger prefers to beat the average when possible. You can follow him on Twitter here. He doesn't own shares of the companies mentioned in this article. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Fool's disclosure policy is anything but average.


Read/Post Comments (6) | Recommend This Article (4)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On March 29, 2012, at 1:25 PM, cp757 wrote:

    Dan I like this article and you point to the "Dollar-cost averaging" approach to investing. I would also like to point out how important dividend reinvesting is. Las Vegas Sands will give the investors 1 dollar a share this year but next year it will be higher. Every ninety days they send you a check and you can put some of your savings with it and buy more shares. Lazard Capital views Las Vegas Sands as the best growth story in the gaming group and keeps a Buy rating on the stock. Our fair value estimate of $74 per share is unchanged. We continue to view LVS as undervalued, with the earnings per share to increase at a more than 30% compound annual rate in the next five years. They feel LVS will get 52% of the mass market share in Macau. That means the dividends will get bigger each year and in just a few years the dividend will be 3 dollars a share that you could put with your money to buy more shares. I agree with you. The wealth-maker is alive and well and Las Vegas Sands is the best wealth-maker .

  • Report this Comment On March 29, 2012, at 2:09 PM, TMFCrocoStimpy wrote:

    Dan,

    Another interesting counter-argument to the research showing subpar results is in the risk analysis. Though dollar cost averaging may produce, on average, lower returns when applied to investing in an index over a 12 month period (compared to the lump sum at the beginning), the likelihood of substantially lower returns exists for the lump sum scenario. Basically, you are trading some potential upside from the lump sum investment for risk protection against a poor timing in the market. On average you may be better off with the lump sum, but as an individual you will have greater protection by spreading yourself out over time.

    -Xander (TMFCrocoStimpy)

  • Report this Comment On March 29, 2012, at 3:07 PM, Merton123 wrote:

    Dan - you may want to do a follow up article about divident reinvestment investment policies (DRIP) that various companies have. This way people can dollar cost average with small amount of money into selected companies. Several companies allow investors to actually invest at a discount since the company actually receives your investment dollars and can put it to use in their business

  • Report this Comment On March 29, 2012, at 3:10 PM, demarisann wrote:

    The following is from LINN's FAQ link.

    "LINN Energy is not a MLP or a corporation, but a publicly traded limited liability company with partnership tax status."

    erv

  • Report this Comment On April 05, 2012, at 1:58 AM, cp757 wrote:

    Of the more than 12,000 public companies traded in the US, there are only six with the combination of a market cap over $10 bn, a 2011-2013 revenue compound annual growth rate of more than 20 percent, and a 2013 estimated free cash flow yield of more than 8 percent. Those companies are Apple, Las Vegas Sands, NetApp, Baidu, Ensco and Vertex.’

  • Report this Comment On April 07, 2012, at 11:42 AM, cp757 wrote:

    AAPL Revenue is 127.84B and comes from marketing mobile communication and media devices but how long to get to 639.2 billion? Over the last three years the stock is up 625%

    LVS Revenue is 9.41B and comes from operating various integrated resort properties but how long to get to 47.05 billion? Over the last three years the stock is up 3,600%

    NTAP Revenue is 5.96B and comes from networked storage solutions but how long to get to 29.8 billion? Over the last three years the stock is up 250%

    BIDU Revenue is 2.30B and comes from Internet search services for China but how long to get to 11.5 billion? Over the last three years the stock is up 800%

    ESV Revenue is 2.84B and comes from offshore contract drilling but how long to get to 14.2 billion? Over the last three years the stock is up 100%

    VRTX Revenue is 1.41B and comes from commercializing small molecule drugs but how long to get to 7.05 billion? Over the last three years the stock is up 50%

    Each of those stocks are great stocks and the arbitrary numbers on future revenue was set at 5 times current revenue. That to me is the question you need to ask. How reasonable is it that the stock's you pick will grow revenues. When you narrow the list from over 12,000 stocks and have an understanding of the 6 stocks left, you can decide which ones to buy. Apple is estimated to be at over 600 billion by 2015 and due diligence would give you an answer as to what you think that stock can get to. Each of those stocks has a high cost to entry which makes it harder for the competition to catch up to the market share they earn and keeps profit margins high.

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Dan Caplinger
TMFGalagan

Dan Caplinger has been a contract writer for the Motley Fool since 2006. As the Fool's Director of Investment Planning, Dan oversees much of the personal-finance and investment-planning content published daily on Fool.com. With a background as an estate-planning attorney and independent financial consultant, Dan's articles are based on more than 20 years of experience from all angles of the financial world.

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