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
Reinvesting dividends can act to supplement an explicit dollar-cost averaging method. So for instance, using high-yielding master limited partnership Linn Energy
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.