Market Chums Raise Stakes of Dollar Cost Averaging.

IN turbulent markets the ancient investment strategy known as dollar cost averaging really gets a chance to show what it can do.

Wouldn't you know, turbulent markets also spotlight the weaknesses and limitations of that same strategy. So what better time to take a close look at it?

Dollar cost averaging uses a simple mathematical trick to pursue a money-management objective familiar to all investors - buying low. The secret is that equal amounts of money buy more shares of a stock or mutual fund when the price is low than when the price is high.

If you make $1,000 investments in a stock at $4, $8 and $12, your average cost will come in below the average price of $8. To be exact, since you bought 250 shares at $4, 125 shares at $8, and 8333 shares at $12, the average cost works out to $6.54.

If you can sell your 458.33 shares at $84 the midpoint of the range in which the stock has fluctuated during the time of your investment, you pocket $3,666, before any commissions and taxes. (It's fair, by the way, to exclude commissions and taxes because if you do this with a no-load mutual fund in a tax-favored retirement account, you avoid or defer paying either.)

You come away with a 22.2 percent return on your money -- not bad for a couple of years work in "trading range" conditions.

Multiplier effect 

The wider the fluctuations in the security's price, the stronger the effect. If we bought in the narrower range of $5, $8 and $11 instead of $4, $8 and $12, our $3,000 would buy us 415.9 shares, for an average price of $7.21. Proceeds when we sold at $8 would be $3,327, or a return of 10.9 percent -- less than half the percentage payoff in the first example.

So dollar cost averaging thrives on what Wall Street people call "volatility." By that reasoning it should be in its element now, given conditions in which the Nasdaq Composite Index has risen or fallen by at least 39 percent in each of the last four years. (That's up 39.6 percent in 1998, up 85.6 percent in 1999, down 39.3 percent in 2000, down 39.5 percent through the end of summer in 2001.)

If I've been following a textbook averaging strategy in a security that tracks the Nasdaq index, it doesn't have to get back to its old highs above 5,000 for me to make out well. Something a shade better than halfway between today's 1,500 and there -- say around 3,500 -- will be good enough.

Ah, but is the index going to get back to 3,500 any time soon? Even if we assume that stocks in general will recover eventually from the 2000-01 bear market, we don't know that the distinctive sample of stocks that dominate the Nasdaq market will share fully in that comeback. On a still more focused basis, one can think of certain Internet specialty mutual funds where the chances of a revival look remote at best.

Risk remains

In dollar cost averaging even more than many other ways of investing, you must pick your vehicle wisely. One candidate that springs to mind is a broadly diversified index fund. As times change, so normally should the makeup of an index that spans all sectors of a market. Or you might opt for a broad managed fund that you consider more closely attuned than an index to your risk preferences.

Let's not bog down in the index-vs-managed funds debate here. The point is, you want a fund or selection of funds in your dollar cost averaging plan that promises long-term reliability, flexibility and diversification. In the inevitable down spells of a long dollar cost averaging program, like the one we're grappling with now, those characteristics can serve as bulwarks against the fear that you might be throwing good money after bad.

In an averaging strategy that sort of risk always exists. Averaging is easy at the beginning, when you have only small amounts in the pot and your goal lies years in the future. As you put more time and money into the strategy, the stakes go up.

Chet Currier is a columnist with Bloomberg News