Last Updated Sep 27, 2010 9:00 AM EDT
In my last post, we saw a situation where dollar-cost averaging (DCA) may be your best choice. But it's important to note that it simply doesn't make sense from an investing standpoint.
From an academic perspective the answer to the question of when to invest is very simple and has been known for a long time. The June 1979 issue of the Journal of Financial and Quantitative Analysis contained an article by George Constantinides entitled "A Note On The Suboptimality Of Dollar Cost Averaging as an Investment Policy." Constantinides demonstrated that DCA is an inferior strategy to lump sum investing. This was followed in 1992 by a paper published in the Financial Services Review (Vol. 2, Issue 1) by John Knight and Lewis Mandell "Nobody Gains From Dollar Cost Averaging: Analytical, Numerical and Empirical Results."
Knight and Mandell compared DCA to a buy and hold strategy and then analyzed the strategies across a series of investor profiles from risk averse to aggressive. The authors noted that: "Brokerage firms endorse DCA primarily with two rationales. First, they state that returns are increased because more shares are purchased when prices are low and fewer when prices are high. Secondly, they assert that DCA enhances investor utility by preventing an ill-timed lump sum investment. Our results do not support either of these contentions."
They concluded: "Using three separate methods of comparison, we have shown the lack of any advantage of DCA relative to two alternative investment strategies. Our numerical trial and empirical evidence, in consonance with our graphical analysis, both favor optimal rebalancing and buy and hold strategies over dollar cost averaging."
Unfortunately, despite the evidence we still hear investors and advisors recommending DCA. They're either unaware of the evidence or the simple logic -- since there's always an equity risk premium (as stocks have higher expected returns than bonds), common sense tells us to invest all at once. Unfortunately, we don't always base decisions on logic or evidence. In fact, the stomach (emotions such as fear) often plays a far greater role in decision-making than the head (logic).
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