The Downside of Dollar-Cost Averaging

With dollar-cost averaging, investors accumulate shares of an investment over time, investing set sums on a set schedule. (Think, for example, of the automatic withdrawals from your paycheck into your 401(k), or how your Aunt Alice invests $200 into her favorite stocks every few months.) It would seem hard to argue against dollar-cost averaging, which makes sense in many ways:

• If you don't have a big lump sum to invest in a stock or fund that you'd like to own, you can buy your desired stake piece by piece.
• If you're not sure where the market or a stock or fund is headed in the short term, and you don't want to commit all your dollars at once right now, you can invest some of them now, and some later, and some more after that. The dollar-cost averaging approach can be handy for the unsure or the risk-averse. (For example, if you're afraid of investing all your current cash right now, you can dribble the money in over time.)
• It can take much of the thinking out of your investing decisions. Sometimes, for whatever reason, we get paralyzed and don’t invest -- maybe we can’t decide whether now is the right time, or we just put it off. If you're a regular dollar-cost averager, you're taking some action, which is often better than no action at all.

Less than optimal
If you really don't have much money with which to invest at any one time, dollar-cost averaging may be a sensible option for you. And with 401(k)s, dollar-cost averaging is the way to go. I'm not here to dismiss the strategy completely.

But if you're able to invest lump sums, that might be a smarter move. Why? Well, think about the stock market's overall trend: Sure, it's a jagged line, dipping now and then, and even crashing on occasion. But overall, over long periods, it has gone up, averaging about 10% per year.

If the market goes up significantly more often than it goes down -- as is the case with most healthy stocks -- then you'll end up paying a higher average price for your investment by dollar-cost averaging than by plunking in a lump sum. Indeed, a landmark 1994 study found that the lump-sum approach worked better when investing in the S&P 500 in 40 out of 65 studied years. More recent studies have also found dollar-cost averaging to be suboptimal.

Tackle risk in other ways
So what should you do if you're skittish? Well, instead of thinking that you’re helping yourself by averaging in, perhaps look at the composition of your portfolio. Accept that the market is simply volatile. Expect some big swings in value, which won't matter as much as you think over many years, if not decades.

One great idea is to turn to stocks that are healthy dividend payers. They can give you the best of both worlds: Even if you invest a lump sum all at once when you buy the stock, you can choose to reinvest your dividends into additional shares, which will bring you some of the same benefits that a dollar-cost averaging program does.

Here are some contenders you might want to research -- each is rated with five (of five) stars in our Motley Fool CAPS community:

Source: Motley Fool CAPS.

The power of long-term dividend investing is very compelling. Dividend stocks can serve you well whether you invest using a lump sum or via dollar-cost averaging. Just make sure you think twice before dollar-cost averaging, and make sure it’s the right approach for you.