Averaging Can Help During Rough Times

If we enter a stretch of rough weather in the stock market, remember the dollar-cost-averaging principle when buying mutual funds.

Downward markets take advantage of this risk-reducing strategy.

Under dollar cost averaging, equal amounts of money are invested on a regular basis--say, $100 each week, month or quarter. When the price of your mutual fund shares climb, your fixed investment buys fewer shares. But when prices drop, you purchase more.

Dollar cost averaging thus allows you to ease into stock funds gradually. When investing a lump sum, by contrast, you face the risk of putting all of your money to work at what could turn out to be a peak price.

An averaging strategy assumes the stock market will eventually bounce back from any swoon, as it always has. Individual stocks might not rebound, but well-diversified equity funds can be expected to recover on a rising tide.

“Even if you buy every share at the same price, the approach makes sense because it’s a way to invest regularly and systematically,” says Jerry Tankersley, director of policy planning at Prudential Securities in New York. “The primary benefit of dollar cost averaging for most people is the discipline.”

There are other attractions:

* Fund groups sometimes waive or reduce their regular investment minimums for people who agree to sock away cash on a routine basis.

For example, Invesco Funds of Denver ([800] 525-8085), Strong Funds in Milwaukee ([800] 368-1030) and T. Rowe Price Associates of Baltimore ([800] 638-5660) allow investors to open accounts for a minimum $50 monthly purchase pulled automatically from a bank account. All three firms waive their normal initial requirements of $1,000 to $2,500.

* You don’t necessarily need to commit new cash to enjoy the benefits of an averaging strategy. Many fund groups will allow you to divert dividends paid by one fund into another. For example, conservative investors can reinvest their bond fund proceeds into a stock portfolio as a way to ease into a riskier position.

* Dollar cost averaging also can be used in reverse, as a way to sell shares gradually. You can accomplish this through automatic-withdrawal plans at many fund companies. You might pursue this approach if you think prices will keep rising and you don’t yet need to pull out all of your cash.

* Dollar cost averaging can help reduce the sales charge on funds you buy through a broker. Most load funds cut their front-end commissions for customers who agree to invest a minimum amount of cash, perhaps $25,000 or $50,000, with heftier discounts available on larger amounts. By signing a “statement of intent,” you can take up to 13 months to satisfy the investment requirement.

* Averaging strategies are flexible, in the sense that you decide how much to put away and how often. “Some people do it only once a year, with their tax refunds or yearly bonus,” Prudential’s Tankersley says. “But I’d suggest quarterly or monthly.”

The main benefit of dollar cost averaging is probably the ability to take some emotion out of the investing process because you know you receive the consolation prize of buying more shares even when prices are dropping.

But if you can stomach the market’s twists and turns and can hang tight for many years, you still might fare better by putting all of your cash to work at once because of the market’s tendency to rise over time.

T. Rowe Price ran a study looking at the performance of Standard & Poor’s 500-stock index from 1950 through 1993, comparing one investor who committed all of his money at the start of each year and another who spread the same amount over 12 equal monthly installments.

The lump-sum investor generated higher returns in 30 of the 44 years from 1950 through 1993. More significant, he earned better results in 39 of the 40 rolling five-year periods, the only exception being the five-year stretch from 1973 through 1977.

“Putting money in gradually would have protected you in years when there was a downward trend in the market,” says Steve Norwitz, a T. Rowe Price spokesman. “But if your outlook was five years or more, you would have done better putting you money in upfront, assuming you had the cash to do so.”

Russ Wiles, a financial writer for the Arizona Republic, specializes in mutual funds.