What is dollar-cost averaging, and why is the investment community so divided on it?

Reading the personal finance and investment literature today is a little like visiting a traveling circus you loved as a child—the same games are there, and the carnies have the same lines ("Step right up for the ride of your life!"), but this time it's more frightening than fun. The promise of a comfortable retirement now seems especially elusive, yet there's not much new advice out there on how to invest. Many advisers have historically recommended dollar-cost averaging, with Suze Orman calling it "the single best way to minimize your risk of buying shares at the wrong time." Plenty of academic finance studies have shown it to be a flawed strategy, but last week's Big Money broadside against Orman, which included criticism of DCA, provoked a spirited defense from many readers. So DCA is still in vogue. But what is dollar-cost averaging anyway, and why does it remain so attractive?

It's an intuitively attractive way to combat the vagaries of the stock market. The idea behind DCA is that you take a batch of mattress-ready money and move into the stock market (or bond market, or mutual funds, or some combination) in installments over a set period of time, rather than all at once. By doing so, the idea goes, you are less susceptible to market volatility, because you'll be putting new investments into stocks when they are down as well as when they go up. Proponents give some simple examples to walk prospective investors through the process.

But the inconvenient truth is that DCA usually doesn't give you the biggest payoff. The mathematical "proof" that DCA is "suboptimal" was given by University of Chicago business professor George Constantinides in 1979. "Replacing one major gamble on a temporary shift of prices by a number of smaller gambles" doesn't necessarily work, especially if you remember that dollar-cost averaging cuts both ways—that there are occasions when cash is actually more valuable than a potential stock investment. (See a layman's walk-through of Constantinides' argument here.) Subsequent data-driven research showed that, under a variety of different actual historical time horizons, taking that big gamble up front worked better over the long haul. And part of the critique of DCA is that it demands that investors fly blind—they should continue to follow a strategy they decided upon months or years ago without the benefit of new information. Assuming better, more, or different information is available, you might change your pacing, or your choices, as you go. DCA doesn't allow that.

Of course for some advisers, it's that very ignorance of new information that brings bliss. Dave Ramsey, an Orman competitor on the pop finance circuit, makes the rationale behind the dollar-cost averaging recommendation clear. It will "make you emotionally capable of investing even if the stock market drops. If you put money into mutual funds in a lump sum, you may freak out if the market dips." DCA is as much a psychological strategy as it is a piece of investment advice. Charles Schwab, which publishes historical demonstrations of the supremacy of the lump-sum approach on its Web site, recommends DCA for some people on similar grounds: DCA "prevents procrastination, minimizes regret, and avoids market timing issues."

There are other psychological issues. Those examples the DCA endorsers show you? They're more likely to present hypothetical situations where the stock starts high and then declines. Plus, dollar-cost averaging sounds sensible, because it's covered under a broader umbrella of other financial planning choices that few people would disagree with: for instance, "paying yourself first" by dedicating a portion of each paycheck to an investment portfolio or a 401(k) (note that that's different from segmenting a lump sum over time).

An underlying "psychological" concern, beyond the fear of the market generally and a propensity to pull out when nervous, is an investor's overall risk tolerance. In this regard, DCA has been shown to be helpful. But other things may matter more—portfolio mix, for instance (how much you hold in bonds vs. stocks, mutual funds, cash, and illiquid holdings) helps investors allocate their investments based on how much risk they want to take on and when they'll need access to cash. And of course, an adviser's overreliance on just one technique forgets the broader range of assets, tools, and individualized attention that an investor needs: The Certified Financial Planners Board of Standards' certification exam covers 89 topics, of which DCA is just one part of one topic.