The Smart Way to Bottom-Fish

If you're still in the market for stocks -- and we think you should be -- there's no shortage of attractive bargains out there. But trying to choose among all those cheap shares is like trying to catch falling knives: If you're not really careful, you'll end up with nothing but a bloody hand.

Of course, if safety's what you want, then you can wait out the recent market turmoil on the sidelines by holding substantial amounts of cash. With short-term Treasuries yielding around 2%, though, every day you're in a money-market fund means another day of losing purchasing power to inflation.

Isn't there a better way? There is -- with an old strategy that's been out of favor for quite a few years.

Dollar-cost averaging: It's back!
If you want to start moving back into the market, but aren't sure that the worst is over, dollar-cost averaging is a good compromise. If stocks continue to fall, then you'll have limited your losses by not spending all your capital all at once. If they rebound, however, you'll earn some gains that you would've missed by keeping all your money in cash.

Although most people think of dollar-cost averaging as a strategy for mutual funds, the rise of low-cost discount brokers has made it a viable strategy for individual stocks and ETFs as well. As an example, take a look at some promising stocks we surveyed at the beginning of the year. Say one investor decided to jump in all at once with a $6,000 investment on Dec. 31, while the other used dollar-cost averaging by buying $1,000 in shares in each of the past six months.

Source: Yahoo Finance. Final values as of Jun. 30, 2008. Dollar-cost averaging example assumes purchase on last trading day of each month.

As you can see, going with a dollar-cost averaging strategy over the past six months helped cushion some of the losses in several of these stocks.

The shortcomings of dollar-cost averaging
Like most strategies, dollar-cost averaging doesn't always work well. Historically, stock prices have risen far more often than they've fallen. Under those normal conditions, studies have shown that you're better off taking the plunge all at once. You can see that in our example -- with advancing stocks like Marvel and Buffalo Wild Wings, you would've done better buying in a single purchase.

But academic studies can't account for the psychological impact of immediate losses on your investments. There's nothing more depressing than putting your money into a promising stock, only to see its price drop right after you buy. If it drops far enough, you might second-guess your thought process and dump the stock -- often at exactly the worst time.

So even if dollar-cost averaging leaves some money on the table, its downside protection, along with the calming effect it has on your nerves, could make it the right way to go for you.

More on making the best of bad markets:

• The best stocks to help your portfolio survive a recession.
• How you can buy the inevitable winners of tomorrow.
• Why you need to pay attention if you don't want to go broke.