One of the questions I am asked most about involves dollar-cost averaging, which involves investing a lump sum of money at regularly scheduled intervals. Two severe bear markets (2000-02 and 2008) and the latest crisis have caused many investors to become too nervous to make lump-sum investments. We've reviewed some of the academic literature on DCA before, but a new paper sheds some additional light on the subject.
In the paper "Does Dollar-Cost Averaging Make Sense for Investors?" the authors begin by asking when the DCA strategy won't work. Their answer is that generally, it won't work when prices rise. When markets are moving up, new money is being invested at a higher cost. On the flip side, this strategy will work over the long run if markets are moving downward, as every new purchase is made at a lower cost than the previous one. However, it's important to see which case is more likely. The S&P 500 Index produced positive returns in more than 60 percent of the months between January 1926 to December 2010 and in more than 70 percent of the years between 1926 and 2010. Thus, the answer should be obvious.
The authors then set up the following test. A portfolio with $1 million was to be invested in the S&P 500 either according to DCA or all at once. (Transactions costs were ignored, which favors DCA's additional trading.) The portfolio following DCA invested 1/12th at the beginning of each month. The study covered rolling 20-year periods from 1926 through 2010.
Investing all at once was the better strategy in 552 of 781 possible periods -- more than 70 percent of the time. In addition, in the roughly 30 percent of the instances in which DCA outperformed, the magnitude of that outperformance was less than when following lump-sum investing. Specifically:
- When lump-sum investing outperformed, the average outperformance was $940,301 on the initial $1 million investment.
- During the 229 periods in which DCA did better, the average cumulative outperformance was $769,311.
It's important to note that even though there's no logical reason to employ a DCA strategy, it might make sense for some investors to use it because of emotional issues.
DCA is a risk-averse strategy since you're holding cash until the plan is fully implemented. The lower volatility investors experience could explain the popularity of the strategy. Behavioralists hypothesize that DCA investors seek to minimize the potential regret (and pain) of investing a lump sum in a risky asset.
The bottom line is that while there's no logical reason to DCA (as it's an inferior approach), DCA may still serve a purpose. If you are so risk averse that you would not invest if you were forced to choose between investing a lump sum or not at all, DCA becomes "the lesser of evils."
Photo courtesy of taxbrackets.org
More on MoneyWatch:
When Dollar-Cost Averaging Makes Sense When Dollar-Cost Averaging Doesn't Make Sense 9 Bits of Conventional Wisdom You Should Ignore The Behavior of Individual Investors: To Err Is Human International Investing Myths You Shouldn't Believe
Three ways I can help you become a wiser investor:
for more features.