Dollar cost averaging is an investment “strategy” that is credited with almost magical abilities by many investment advisers. The argument goes something like this: You can’t pick the highs and lows of the market so just invest a constant amount in regular intervals and you will buy more shares when the market is lower and fewer shares when the market is higher. Thus your average cost per share will be lower over time. Well, something has always bothered me about this argument but I could never quite put my finger on it. The idea of a mindless process producing better than average results over time just didn’t sit well - not to mention that this argument sounds vaguely like the crazy practice that some people engage in where they buy more of a stock that has moved down from their initial purchase price only because that will lower their average cost (like they still aren’t in the hole on the original purchase?).
Don’t get me wrong; there are clearly a few benefits to dollar cost averaging, not the least of which are psychological. First, with a disciplined investment strategy you won’t be tempted to time the market. Second, when prices drop the blow is softened by the belief, rational or not, that you now get to buy more shares at a lower price. But aside from the psychological benefits there is also a savings discipline that comes with dollar cost averaging. Your income is earned in a relatively steady stream and dollar cost averaging forces you to save it as it is earned.
But this notion of being economically better off simply by spreading out your investments over time just doesn’t hold water. All you really need to know to see the fallacy of this claim is that the market tends to move up over time - i.e. it has a positive expected return. Therefore, the faster you put your money in the faster it’s going to grow. So, if you’re sitting on a pile of money the smartest strategy is actually to invest it all as soon as possible in one big lump sum. Sure, it may go down shortly after you invest but it’s just as likely to go up. End of discussion.
Well, there are probably a lot of advisers out there that aren’t satisfied with this explanation and that’s why Dr. John Greenhut, an Associate Professor of Finance in the College of Business and Technology at Texas A&M University, wrote a rather comprehensive expose on Dollar Cost Averaging. His article, Mathematical Illusion: Why Dollar-Cost Averaging Does Not Work, appears in the October 2006 issue of The Journal of Financial Planning.
In his article Dr. Greenhut exposes the mathematical illusion that seems to produce stellar results from dollar cost averaging. As he points out, the apparent success of this technique often results from unfair or flawed assumptions about stock price movements that work in favor of dollar cost averaging - namely, that assumptions are often made that stock prices vary around a mean by constant dollar amounts when in fact the variation actually tends to occur in constant percentage terms. Dr. Greenhut provides ample illustration that these assumptions are flawed and he proves that lump sum investing is at least as good as dollar cost averaging. However, he then goes on to argue that since the market is always expected to drift upward lump sum investing is actually superior to dollar cost averaging and he cites the academic research that supports this conclusion. He even goes so far as to examine historical data on over 1600 companies and empirically demonstrates that dollar cost averaging is only superior if a stock is in a downtrend.
Since you don’t know ahead of time if the market or an individual stock is going to be in a downtrend and since your best guess at any point in time is that an investment will drift upward you might as well invest your money as fast as possible and forget about dollar cost averaging - unless of course you need a little psychological boost.
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