Does Dollar-cost-averaging work?

Dollar-cost-averaging (DCA) refers to the investing strategy whereby an investor puts in a fixed-dollar amount into an investment at regular intervals. The idea is that with a fixed-dollar amount, the number of shares bought will be higher when the share price is low, and lower when the price is share price is high; which on average will produce a “lower cost per share” outcome.

The paper “Mathematical Illusion: Why Dollar-Cost Averaging Does Not Work“, in the FPA journal, argues however that:

Absent any benefit from stock price volatility in reducing average cost, the performance of DCA rests on the trend in stock prices, with DCA outperforming in downward markets and lump sum outperforming in upward markets. Since the latter case is the norm over time, customary empirical findings in the finance literature of underperformance by DCA are explained.

The theory in this paper is confirmed by examining a broad sample of stocks, contrasted over the high-growth trend in the second half of the 1990s against the general market malaise over the following half-decade. In the absence of this trend, DCA and lump sum provide equivalent results.

In other words, this paper argues that statistically, there is no advantage whatsoever in practising DCA. The benefits of using DCA, if any, are purely of a psychological appeal.

Note: The context of DCA here refers to an investor with a lump-sum amount to invest, but instead chooses to practise DCA. This is quite different from the case whereby an investor make regular contributions (by necessity) to his/her investment accounts from the paycheck.

5 Comments

  1. samerwriter

    Statistically, you can beat roulette in Vegas by betting on red or black and doubling your bet every time you lose.

    But in reality, you have a very large chance of going bust. I imagine the same is true of lump-sum investing vs. DCA. (OK, lump-sum investing isn’t quite as disastrous as betting Martingale).

    Yes, in aggregate clearly lump sum is better. But an individual needs to be concerned about ensuring a high probability of success (where “success” is defined by exceeding some threshhold, not attaining massive wealth).

    The paper does address this briefly, but claims that the same benefit can be realized through prudent allocation. I view that as a copout. 99% of us aren’t capable of coming up with and maintaining an ideal allocation.

    Reply
  2. indexfundfan (Post author)

    Hi samerwriter, I tend to agree some form of DCA is usually easier to accept. There is an article on Bill Bernstein’s Efficient Frontier website that suggests a 6- to 12-month DCA; this has performed well based on historical returns:

    http://www.efficientfrontier.com/ef/997/dca.htm

    Reply
  3. choozm

    another indexfundfan’s post about DCA: “think risk reduction”

    http://www.indextown.com/archives/2006/04/16

    Reply
  4. indexfundfan (Post author)

    Hi choozm,

    Thanks for the link. I forgotten I had the other post too! 🙂

    Reply
  5. Pingback: Does Dollar Cost Averaging Work? | Moolanomy

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