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Archive for Sunday, April 17, 2005

Dollar-cost averaging gets investors better results

April 17, 2005

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This is one of those good-news, bad-news reports. First the bad: During the past 20 years, the average investor in mutual funds that hold stocks earned almost nothing once inflation was taken into account, even though stocks enjoyed terrific gains.

The good news: Investors are catching on. They recently have done a better job -- by sticking with their funds through thick and thin and adopting proven strategies such as dollar-cost averaging.

These are among the results of the 12th annual study of investor behavior by Dalbar Inc., a Boston financial-research firm.

The study found stock-fund investors had returns averaging just 3.7 percent a year from 1985 through 2004, while the Standard & Poor's 500 index, the most widely used stock-market gauge, returned 13.2 percent a year. Annual inflation averaged 3 percent, chewing up most of the investors' gains.

Bond-fund investors did badly, too, with annual returns averaging 2.4 percent during the past decade, vs. 7.7 percent for a broad bond-market index and 2.5 percent for inflation. Bond-fund investors earned just 2 percent a year during the past 20 years, but the index does not go back that far.

Investors do poorly because they tend to buy high and sell low -- the opposite of what they should do. Dalbar research on the flow of cash in and out of funds showed that investors pour money in when markets are doing well, thus paying high prices. They take it out when stocks fall and then wait too long to put it back in, missing much of the rebound.

During the past two decades, for example, the average investor held shares in individual stock funds for only 2.9 years, Dalbar found. For bond funds, it was 3.2 years.

These "retention rates" represent the time it would take for all a fund's shares to be redeemed, given redemption rates over each period studied.

And that's where some of the good news comes in. Investors slowed the rate of redemptions last year to a pace that would lengthen average stock-fund ownership to 4.2 years. For bond funds, the figure went to 3.2 years in 2004, up from 2.6 years in 2003. People with asset-allocation funds, which own a mixture of stocks, bonds and cash, held their funds the longest, redeeming at a 5.3-year pace last year, compared to a 20-year average of four years.

"Investors are holding on to their mutual funds for longer, and this is a very good indication that previous imprudent behavior is being corrected," Dalbar said. "If maintained, the effect of this change will undoubtedly be higher investor returns."

How much higher?

The researchers gave a hypothetical case, looking at how an investor might have done by using dollar cost averaging during the past 20 years. With this strategy, a person invests equal sums at regular intervals -- $100 per month, for instance.

Committing to do this, as many people do with 401(k) plans, helps investors overcome the emotional roller-coaster that makes them buy high and sell low.

Also, a given sum will buy more shares when prices are down, fewer shares when prices are up. Investing a set amount thus allows you to reduce the average price you pay per share, boosting profits.

In fact, this simple strategy can boost profits a lot.

An investor who put a total of $10,000 into average stock funds from 1985 through 2004, at a rate of $41.67 a month, would have ended up with a portfolio worth $35,439.

But someone who followed the investment pattern of the average investor would have seen the same $10,000 grow to just $20,816. This investor would have put big sums in when stocks were hot, less when they were cold.

As a long-time practitioner of dollar cost averaging, I can note one other benefit: You don't have to make a lot of decisions and you don't second-guess yourself. So you sleep better.

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