Dollar cost averaging
||This article is incomplete.|
Dollar cost averaging (DCA) is the method of buying a fixed dollar amount of a particular investment such as equities on a regular schedule, regardless of the share price. More shares are purchased when prices are low, and fewer shares are bought when prices are high. The purchases are made regardless of the security price. It results in more shares being bought when the price is down and less shares being bought when the price is up. By dividing the total sum to be invested in the market (e.g. $24,000) into equal amounts put into the market at regular intervals (e.g. $2000 per month over a year), DCA reduces the risk of incurring a substantial loss resulting from investing the entire "lump sum" just before a fall in the market. Dollar cost averaging is not always the most profitable way to invest a large sum, but it minimises downside risk. An alternative approach is lump sum investing, which is to make the entire investment immediately.
Academic research indicates that lump sum investing provides better long-term returns, but if the investor is primarily concerned with minimizing downside risk and potential feelings of regret then DCA may be preferred.
DCA is sometimes used interchangeably with the phrase Periodic Investing, which is a systematic method of making regular contributions to an investment portfolio. In this sense, DCA refers to making contributions whenever money is available, rather than using discrete amounts from an existing lump sum at predetermined intervals.
Resorting to DCA can be indicative of a dangerous behavioral pitfall. It is akin to a Boiling frog approach. If one is unwilling to accept the risk of his portfolio's target asset allocation by dumping everything into it, it would be illogical to do it over a longer time frame.
Holding a portfolio without selling part of it or adding to it is equivalent to selling the entire portfolio and buying it right back for the same price (with no transaction fees or taxes). In other words, by doing nothing, one is effectively deciding to reinvest the current portfolio into its current effective asset allocation.
Using DCA instead of adding a lump sum to an existing portfolio is equivalent to changing the asset allocation, only to ease back slowly into it, like a boiling frog. While this might feel better, it offers no protection against stocks crashing just at the end of the DCA period. If one is unwilling to accept the full risk of the portfolio's target allocation, the solution is to change the target to something bearable and invest accordingly.
One Financial Wisdom Forum post makes the following analogy: “If you are contemplating going swimming in a very cold lake, do you jump in, or do you edge in, inch by inch? If this is causing a real dilemma for you, perhaps you shouldn't go in at all.” Translated back into investment terms, you might want to find a warmer lake to swim in, i.e. a more comfortable asset allocation.
Discovering the effective willingness to accept risk
Lump sums are actually an awesome tool to help better assess our difficult-to-discover willingness to accept risk. It's easy to blindly accept more risk than we think by investing in small increments. We tend to only concentrate our attention on each small contribution; as a result, the risk seems small. We think: "What if I lost 50% of this $500 I'm investing? I would temporarily lose $250. I make many times that each months! Anyways, I would get the opportunity to buy stocks on a rebate. OK. Let's go with it!". We forget that we are, in fact, deciding to (re-)invest the entire portfolio into it's current effective asset allocation.
The danger, from a behavioural point of view, is to discover our unwillingness to accept as much risk after the fact, after stocks have crashed and we've lost more than we were willing to lose. Some investors discovered their effective willingness to accept risk too late, in 2008-2009, and reacted in a self-destructive manner. Some even got out of stocks entirely. Others, with an allocation to bonds, simply stopped rebalancing their portfolio; they were willing to buy stocks at high prices a few months earlier, but unwilling to buy more after a 50% rebate! "Buy high, sell low" is not a good investing recipe.
Beyond our hard-to-discover subjective willingness to accept risk, there's our objective capacity to assume the consequences of a bad outcome. In 2008-2009, what caused some U.S. workers to sell part of their stock holdings at a rebate was that they lost their job and needed the money to pay their mortgage and other expenses. They didn't sell because they were afraid of stocks, but because they had no alternative.
New investors with no stock market experience might find themselves psychologically unable to invest a lump sum, even using a reasonable asset allocation. For them, any lake is too cold. In such a scenario, although DCA is statistically expected to provide lower returns on average, it might be the only way to deploy the money.
Three other behavioral justifications to adopt DCA are:
- First, a mathematical property of DCA is that over any arbitrary investment period, the average price paid is always less than the average price. Though this property is unrelated to the issue of optimality, it makes DCA a compelling strategy for many investors, given the way they frame sequential decisions.
- Second, it is well-established that the pain of regret exceeds the joy of pride for most humans. A 30% decline in stocks causes much more pain than a 30% increase causes joy, and if the pain of regret is sufficiently acute, it may prevent some investors from ever investing in stocks. (...) Following a rule such as DCA reduces most investors’ sense of personal responsibility, which reduces the level of regret for bad outcomes and enables them to invest in riskier assets.
- Third, rules such as DCA serve to combat lapses in self control that may cause investors to abandon their investment plans at the worst possible time. Thus, DCA may be inferior to the optimal strategy, but is superior to the strategy most investors are likely to adopt as a result of their human nature.
- Dollar-Cost Averaging (DCA) Definition | Investopedia, viewed January 13, 2016.
- Constantinides, George M., A Note on the Suboptimality of Dollar-Cost Averaging as an Investment Policy, Journal of Financial and Quantitative Analysis, Volume 14, Issue 2 (Jun., 1979), 443-450, viewed November 21, 2013.
- Knight, John R. and Mandell, Lewis, Nobody Gains from Dollar Cost Averaging Analytical, Numerical and Empirical Results, Financial Services Review Volume 2, Issue 1, 1992–1993, Pages 51–61, viewed November 21, 2013.
- Vanguard Research Paper, Dollar-cost averaging just means taking risk later, viewed August 31, 2017.
- As opposed to its target asset allocation. In other words, not rebalancing a portfolio which has significantly drifted away from its target allocation is equivalent to reinvesting the portfolio according to a new asset allocation.
- Financial Wisdom Forum, poster ghariton, Very cold lake analogy, September 3, 2017
- Statman M (1995) A Behavioral Framework for Dollar-Cost Averaging. Journal of Portfolio Management 22:70-78. Available on ResearchGate. Quoted as summarized by Dunham and Friesen (2011) Building a Better Mousetrap: Enhanced Dollar Cost Averaging. Journal of Wealth Management 15:41-50. Available on SSRN.
- Financial Wisdom Forum topic:
- Financial Wisdom Forum topic:
- Financial Wisdom Forum topic: