By Neal Templin

If you have been sitting on the sidelines because stock prices seem too frothy, consider wading into markets step by step instead all at once.

Dollar-cost averaging is an age-old investing tactic that can be particularly effective in volatile markets. In down markets, it can force you to buy equities at bargain-basement prices when other investors are sitting on their wallets or, worse, selling. In up markets, dollar-cost averaging protects you from betting all your chips only to see them tumble in value.

"If you're a nervous investor, the key with dollar-cost averaging is kind of acknowledging that none of us know what is going to happen in the future in the markers," says David Blanchett, portfolio manager and head of retirement research for PGIM, the investment management company of Prudential Financial. "The best thing you can do is stay invested."

How does dollar-cost averaging work?

Let's say you just inherited $1 million and you want to invest it for the long term in stocks. You could invest $200,000 today, another $200,000 in three months, and so on every quarter until you have invested all the money. It will take a year to invest the sum. But if the market falls during that time, you will purchase a chunk of those equities at tomorrow's lower price.

By contrast, if the market continues to rise during the next two years, using dollar-cost averaging will net you less money than buying $1 million of stock today. But even in this case, you will buy some stocks at today's lower price.

Because stocks more often go up than down, dollar-cost averaging over just three months will result in a smaller gain than a lump sum purchase roughly 70% of the time, according to research from Vanguard. If you invest more slowly, say over a year or two, lump-sum investing will be even more advantageous than dollar-cost averaging, says Vanguard Head of Enterprise Advice Methodology Joel Dickson.

But Dickson acknowledges that dollar-cost averaging is beneficial for investors who otherwise wouldn't venture into the stock market. "If the alternative is lump sum versus 'I keep delaying investing,' dollar-cost averaging could be an improvement to just get the money invested," he says.

For investors who want to tweak the dollar-cost averaging strategy to get better performance, there is a technique called value averaging. Like dollar-cost averaging, you invest over time. Instead of investing the same amount each time, you follow a formula to invest more if stocks rise in price and less if they tumble in price. "It's basically dollar-cost averaging on steroids," says Michael Edleson, who wrote the book Value Averaging: The Safe and Easy Strategy for Higher Investment Returns.

Value averaging effectively combines dollar-cost averaging with another age-old portfolio tactic: rebalancing, Edleson says. The challenge with value averaging is that you need to calculate the amount to contribute each time, rather than an equal contribution, which could be a turnoff to investors who treasure simplicity.

There is a far simpler way of value averaging, Edleson says. If you are in an employer retirement plan and contribute money each paycheck, you are dollar-cost averaging. If that money is going into a target-date fund, which automatically rebalances, you are effectively value averaging, Edleson says.

Christine Benz, director of personal finance and retirement planning for Morningstar, sees dollar-cost averaging as an effective risk mitigation tool as investors near retirement when they will begin drawing down their portfolios.

"I do think the anticipated spending horizon is important. For people with really long horizons in your 20s, 30s, and 40s by all means, put that money to work quickly," she says. "But if you're someone who is 55 and came into some money, there I would be a little circumspect about my contributions."

That is all the more true because Morningstar, Vanguard, and several other big asset managers see stocks underperforming over the next decade. They cite high equity valuations as a reason.

Morningstar, for example, predicts annualized 5.6% nominal returns for U.S. stocks for the next decade and annualized 4.9% nominal returns for U.S. aggregate bonds. The stock number is well below historical levels. Some other forecasters are even more pessimistic.

If such sober predictions are correct, the stock market would almost surely have some big drops during that period, making dollar-cost averaging even more attractive. "Easy in and out of the market is probably the best way to do it for most people," says PGIM's Blanchett. "It kind of removes the regrets."

Write to Neal Templin at neal.templin@barrons.com

This content was created by Barron's, which is operated by Dow Jones & Co. Barron's is published independently from Dow Jones Newswires and The Wall Street Journal.

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February 01, 2025 03:00 ET (08:00 GMT)

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