Why not just buy low and sell high? That’s easy enough, right? The classical answer is a resounding no and there are reams of analyses to prove that it’s not a good idea to try to do this. Most arguments against timing make the case that the market is extremely volatile and impossible to predict. It’s extremely easy to miss the best performing days and if you do you will have substantially worse performance than if you had stayed in the market the entire time. I’ve seen many variations of the following analysis [1] over the years:

The bottom line of this analysis is supposed to be that unless you have a crystal ball you are going to miss major upward market moves and you will seriously undermine your returns. In fact, in 1975 William Sharpe published a seminal article on this topic: “Likely Gains from Market Timing”. In this article Sharpe demonstrated statistically that in order to benefit from a market timing strategy you had to guess right 74% of the time. [2]

Historic performance data seems to confirm this conclusion. When Brinson, Hood, and Beebower conducted their analysis of the performance of 91 pension plans from 1974 to 1983 they determined that market timing had detracted from performance by .66% [3]

So maybe we should just end the article here. Why go on? Maybe because everyone believes that they are above average and people don’t like the idea of a passive strategy. More importantly, these analyses don’t tell the entire story.

First, every anti-timing analysis that I have seen, such as the first example given, focuses on the performance of binary strategies – you switch from being 100% in the market to being 100% out of the market. A more prudent strategy, and one that is actually practiced by portfolio managers, involves moderately adjusting your market exposure depending upon some appropriate signal. However, I have not seen this examined in the research.

Secondly, bubbles do occur and after the fact everyone clearly sees how overvalued the bubble assets were. There are historic patterns and there are limits to what is a reasonable price for any asset. If we can learn to leverage this knowledge then perhaps we can boost our returns.

I skimmed through parts of Graham (In case you didn’t know, Benjamin Graham was a young Warren Buffet’s mentor) and Dodd’s 1934 classic book, Security Analysis, in early 2002 and was awe struck by the timelessness of their writings. Considering the parallels between 2002 and 1934, I had to keep reminding myself that the book had been written almost 70 years prior. Let me share a montage of interesting quotes from the book (italics theirs): “…the prices of common stocks are not carefully thought out computations, but the resultants of a welter of human reactions. The stock market is a voting machine rather than a weighing machine. It responds to factual data not directly, but only as they affect the decisions of buyers and sellers…a conservative valuation of a stock issue must bear a reasonable relation to the average earnings. In addition, it must be justified by whatever indications are available as to the future. This approach shifts the original point of departure, or basis of computation, from the current earnings to the average earnings, which should cover a period of not less than five years, and preferably seven to ten years…But it is the essence of our viewpoint that some moderate upper limit must in every case be placed on the multiplier in order to stay with the bounds of conservative valuation. We would suggest that about sixteen times average earnings is as high a price as can be paid in an investment purchase of a common stock…it is difficult to see how average earnings of less than 6% upon the market price could ever be considered as vindicating that price. It would be acceptable only in the expectation that future earnings will be larger than in the past. In the original and most useful sense of the term such a basis of valuation is speculative.” [4]

Notice that Graham and Dodd heavily discounted expectations of future earnings. Maybe they were from Missouri and they never had to figure out what Google was worth but frankly I agree with their approach. It’s hard enough to know what a company really earned over the last 10 years, let alone project future earnings.

Fast Forward to February 2006 at The CFA Institute Risk Symposium and Yale professor Robert Shiller discusses the characteristics of bubbles and how they propagate. He also presents a few compelling market valuation indicators. [5] (Shiller is famous for his 2000 book, Irrational Exuberance, named after a term used by Alan Greenspan in a famous speech. Interestingly, Shiller had discussed the impact of market valuations on returns with Greenspan 2 days prior to the famous speech.) First, he examines the S&P P/E ratios from 1881 - 2005, calculated as Graham and Dodd would have them calculated. The graph below, from Shiller’s Web site, is the same one used in his presentation but is updated through February 2007.

As you might expect the graph shows massive fluctuations, with the most prominent peaks in 1929 and 2000. Of course there are two ways that a high P/E can come back down to earth – either the E can go up or the P can go down and you would have no way to know in advance which was going to occur. However, Shiller analyzed the relationship between the P/E and the subsequent 10 year return. Although the relationship would not make for a very good regression it clearly shows that a high P/E results in lower returns over the next 10 years. In particular, after the lows of 1919 the market averaged more than 15% per year and when the P/E was 20 – 25 the subsequent returns were near zero. So it would appear that Graham and Dodd were correct and that P/E is a valid indicator of fair value. By the way, as of February 2007 the P/E was at 30, which is not a positive indicator.

Shiller also presents his Valuation Confidence Index, which he has calculated since 1990 and which reflects the percentage of investors that believe the market is not overvalued.

Interestingly, the index bottomed out at around 30% right before the market peak in early 2000, which begs the question “if investors believed the market was overvalued then why didn’t they sell?” Maybe they didn’t believe in market timing. Unfortunately, his data only goes back to 1990 so we can’t be sure that this is a valid market indicator but it certainly bears watching. Note that by this measure the market is not currently at risk for a pullback.

In 2002 Pu Shen, an economist at the Federal Reserve Bank of Kansas City, took the P/E indicator a step further and empirically examined the performance of a signaling tool similar to the Fed Model. For the period from January 1962 to December 2000 he tested buy/sell decisions based upon what he calls the “short spread” between the S&P earnings yield and the yield on 3 month treasuries (E/P – 3 month treasury bill yield). (He also looked at the “long spread”, based upon the 10 year yield but that was not as powerful.) He used the tenth percentile of the spread as the signal – i.e. when the spread dropped below the tenth percentile it was time to get out of the market and into 3 month treasuries and when it rose above the tenth percentile it was time to get back into the market. (Note that this is one of those binary strategies.) The idea here is that when the earnings yield on stocks is too close to the yield on 3-month treasuries stocks are not a very good investment. Seems reasonable.

Here is a summary of the important findings from his 39-page paper:

• The buy and hold strategy returned 1.117% per month over the test period while the switching strategy returned 1.322% per month.
• On an annualized basis that amounts to 14.26% vs. 17.07%.
• Whether or not you consider this difference to be statistically significant depends upon how you frame the analysis. I did not find this part of the paper particularly enlightening.
• The switching strategy resulted in a less risky portfolio over time. The Sharpe ratio of the switching portfolio was 0.205 vs. 0.13 for the buy and hold strategy.

Seems like it would be hard to pooh pooh these results. However, Pu also tested switching strategies based upon just the earnings yield and just the 3-month yield and concluded that almost all the predictive power was in the 3-month yield. His interpretation of this result is that trading based upon the 3-month yield keeps you out of the market during inflationary periods, which are not good for the market. I think it’s just as valid to view this from the perspective of higher yields mean a higher discount rate on stocks, which gives lower stock valuations.

While I think this study raises some interesting possibilities, I do have one major concern. Given the amount of historical data available and the varied economic environments that the market has encountered I don’t think 39 years is a long enough time period for this kind of study. In fact, Robert Shiller pointed out that “Since 2000, [the Fed Model] has broken down, and also before 1970, there really was not a correlation. Thus, people seem to have been exaggerating the impact of interest rates on the stock market.” [7] Clearly he is of the mindset that we should focus on the P/E ratio alone and from my perspective there is good reason to believe him. Interest rates are going to go up, they are going to go down, they are going to oscillate around some “normal” level, and you can’t very effectively predict where or when they are going to move. So you might as well take a long-term perspective and focus on the P/E ratio alone. Unfortunately, Shiller did not do nearly as rigorous an analysis as Pu.

A similar analysis from Ned Davis Research shows that extreme values of the S&P P/E can be effective predictors of future stock returns. Analyzing the period from March 1926 to June 2006, using trailing 12 month earnings, they point out that the average P/E has been 15.9 and they have set buy/sell triggers at P/E ratios of 9.3 and 20.2. (I was unable to discover how they determined these thresholds.) 24 months after responding to these triggers the median return of the S&P has been 27.5% after a buy signal and 0.8% after a sell signal.

So where does all this leave us today? The current trailing P/E ratio of the S&P 500 doesn’t look so bad at 15.6. However, based upon Shiller’s 10 year trailing analysis above which shows the February P/E to be 30, it’s clearly north of 30 now, which is darn high. The reason for the big difference is that S&P earnings have been on a rocket since 2002. As long as you have confidence that earnings won’t retreat then maybe valuations aren’t so out of whack. However, consider the data over the past 135 years:

Using Shiller’s entire data set I have determined that the historic earnings growth rate has averaged 1.45% per year and earnings are currently well above the trend line. Picking different time periods than the last 135 years can give slightly different results for the average earnings growth rate but nothing dramatically different. For instance, in a 2002 Yale ICF working paper Ibbotson and Chen stated that earnings have grown at a 1.75% annual rate since 1926. [8]

Each time that earnings have shot well above the trend line in the past they have eventually regressed back to the trend line. There are several reasons to expect that to occur. First, as Ibbotson and Chen point out, earnings just can’t grow faster than the overall economy unless equities are becoming a larger factor in the economy. While the factor share of equities has grown it is not a huge effect. Therefore, one would expect earnings to grow at about the rate of productivity growth, which has been about 2% per year. [8]

Second, market forces also throttle earnings growth. Extraordinary profits invite additional competition, greater employment levels eventually cause labor rates to rise, and high production levels bid up energy and raw material costs. With unemployment at a 6 year low and rising commodity prices we’re already seeing evidence of this.

My belief is that we have been experiencing an earnings bubble – perhaps driven by huge liquidity injections and lax home mortgage originations. It would seem that profits are destined to go down. If that’s the case then Graham and Dodd are correct to be looking at the longer-term earnings average. We could very well be at a market peak right now and, while a complete withdrawal from the market might not be prudent, reducing one’s exposure to stocks might be wise.

[1] ING Special Report: Market Timing, July 2005
[2] William Sharpe, “Likely Gains from Market Timing”, Financial Analysts Journal, Vol. 31, No. 2, March-April, 1975, pp. 60 - 69
[3] Gary P. Brinson, L. Randolph Hood, and Gilbert L. Beebower, “Determinants of Portfolio Performance”, Financial Analysts Journal, Vol. 51, No. 1, January-February, 1995, p. 135
[4] Benjamin Graham and David Dodd, Security Analysis, 1934, pp. 452 – 453
[5] Robert J. Shiller, “Irrational Exuberance Revisited”, CFA Institute Conference Proceedings Quarterly, Volume 23, Number 3, September 2006, pp.16 – 21
[6] Pu Shen, “Market-Timing Strategies That Worked”, Research Division, Federal Reserve Bank of Kansas City, May 2002
[7] Robert J. Shiller, “Irrational Exuberance Revisited”, p. 19
[8] Roger G. Ibbotson and Peng Chen, “Stock Market Returns in the Long Run: Participating in the Real Economy”, March 2002

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The opinions and views expressed in this article do not necessarily reflect the views of InvestingMinds. InvestingMinds did not prepare and does not endorse such content. Please note that this document is intended for general circulation only and the recommendations contained herein do not take into account the specific investment objectives, financial situation or particular needs of any particular person. This document is for information purposes only and it should not be regarded as an offer to sell or as a solicitation of an offer to buy securities or other financial instruments. No part of this document may be reproduced in any manner without the written permission of InvestingMinds.

Authors note: I thought it would be appropriate to keep this article short so if you want some detailed information on how shorting works check out this entry in our encyclopedia.

There comes a time when you may want to take a short position and when that time comes you need to be aware of some of the potential pitfalls and how to avoid them.

First, why would you want to do something like this? Let me give you a few sample scenarios, though there are many others:

1. You are convinced that a particular stock is overvalued and you want to profit when everyone else figures out what you’ve known all along. A side benefit of doing this is that if the company goes bankrupt you never have to close out the short position and thus you avoid paying income taxes.
2. You want to hedge your investments. You like your individual stock selections but you’re nervous about the direction of the market so you sell the market short. Shorting one of the many ETFs that represent various indices will eliminate that market risk from your portfolio.
3. Perhaps you’ve sold a put option on a stock but want to insure yourself against the possibility that the stock will decline. Of course, in this case you will lose if the stock moves up.
4. You find a closed end fund that is selling at a substantial premium and there are comparable closed end funds or ETFs that are selling at net asset value (NAV) or below. You can short the fund trading at a premium and buy the fund trading at NAV.

Aside from the inherent risk of unhedged shorting (like having unlimited downside), there are several other ways you can get stuck with the short end of the stick if you don’t know what you are doing. Let’s start with how shorting is executed and who gets what out of the deal. Your broker borrows a client’s stock and sells it. First and foremost that means that the stock has to be available for shorting. If the stock is not widely held there is a very good chance that your broker can’t find a position amongst all of their clients from which to borrow. Without a lender you cannot execute a short transaction. I’ve run into this dilemma many times. However, your broker has a stock lending department that can help in these situations. They can go outside of their firm and find the shares. For this service you pay a small fee. Fidelity charges 2.5% of the average short value per year.

The next problem you will encounter is that you are now liable for paying the dividends on that stock to the lender. Seems reasonable, right? Yes, but there’s one small problem. You have an investment expense and guess what? You don’t get to deduct it as an investment expense. You see, our government, in their infinite wisdom, taxes you on any dividends you receive but doesn’t let you immediately deduct the cost of any dividends you pay. Instead you are supposed to add the dividend payments on short sales to your tax basis, so you don’t get the tax benefit until you close the position. One would think that a dividend you pay would be like a negative dividend that offsets any dividends you receive, but the world we live in is not symmetrical. (I have no idea what happens when you short against the box and you receive dividends that you simply turn around and pay back out but we can all guess how that story probably plays out.)

As if all this wasn’t bad enough there’s also the small issue of the cash generated from the sale of the stock. I think this is one of those dirty little secrets. When that stock is sold cash comes in the broker’s door, which generates interest. Who gets the interest? There’s only one possibility – the broker quietly pockets the money. I once brought this up with a trader who actively shorts stocks and he uncomfortably admitted that this is something that you can negotiate with some brokers. He claimed to have worked out a deal with his broker to give him a portion of the interest. I tried bringing this up with Fidelity and they acted like I was from another planet. So I just accept this as an unfair cost of doing business. This is just another glimpse into the asymmetrical world we live in: sell some stock and get interest on the proceeds; sell someone else’s stock and you don’t get interest on the proceeds.

Finally, shorting is not even an option in your IRA. I guess it’s viewed as too risky for retirement money.

Given all these problems what do you do? As a first step, before you short something (as in the case of a hedge) look around for alternative plays. Is there something else you can sell that will allow you to get interest on the proceeds? For example, you might be better off selling your GE stock, which is closely correlated with the S&P 500, rather than shorting the S&P 500.

Another alternative is to buy one of the recently introduced short funds (also known as bear or inverse funds). These are ETFs that move in the opposite direction of their corresponding target index. It would seem reasonable that the pros managing these funds have access to techniques that you or I don’t, which allows them to more efficiently take a short position. I just checked the prospectus for the Short S&P 500 ProShares fund (SH) and discovered that they basically have two holdings: S&P swaps via UBS and cash. So instead of shorting the index they’ve essentially achieved the same effect by entering into an agreement with someone who wants to bet on the S&P rising. When the index goes up ProShares pays the counterparty and vice versa. This structure has a benefit to the party taking the long position: they take a long position without tying up cash. So there is an inherent efficiency in this structure, the benefits of which you would expect to be shared by ProShares. In addition, ProsShares earns interest on all the cash that they receive from selling the fund.

The other advantage to these short funds is that you can purchase them in your IRA, which is a bit ironic since they don’t want you taking short positions there.

So, owning this short fund might be better than taking the short position yourself. To check this I compared the two alternatives during a time period between dividend payment dates (to make it easy) when the S&P changed by its maximum amount. From March 27, 2007 to June 4, 2007 the S&P Depository Receipt (SPY) went up 7.87%. Had you shorted it and held cash in the amount shorted (since you didn’t use cash to buy the short fund) you would have lost 7.87%, offset to some extent by interest of .95% (assuming your money market is returning 5%) for a net loss of 6.92%. During this same time period the Short S&P fund went down by only 5.93%. So it appears that during this period of rising stock prices owning the short fund was a better alternative. What I can’t tell you is what would happen during a period of falling stock prices, since these short funds haven’t been around long enough for us to measure that. Perhaps this fund just doesn’t track the index that well. I’ll be keeping an eye on this since I recently purchased the short fund.

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The opinions and views expressed in this article do not necessarily reflect the views of InvestingMinds. InvestingMinds did not prepare and does not endorse such content. Please note that this document is intended for general circulation only and the recommendations contained herein do not take into account the specific investment objectives, financial situation or particular needs of any particular person. This document is for information purposes only and it should not be regarded as an offer to sell or as a solicitation of an offer to buy securities or other financial instruments. No part of this document may be reproduced in any manner without the written permission of InvestingMinds.

Before you all start rolling your eyes at me for stating the obvious, hold on and hear me out.  It is one thing to say don’t lose money, it is quite another to do it.  Long-term investment success depends on not losing, i.e. not taking major losses.  If you focus on the downside (risk), the upside (profit) will take care of itself.

Too often investors get caught up in the thrill of victory focusing their attention on big gains and “making a killing” in the market.  Slow and steady wins the race.  Speed kills. Even though we know that accidents most often happen to drivers that are speeding and going too fast, the allure of fast money and the quick buck can lead to straying from a disciplined investment approach and taking long shot wagers.  When this happens, you have left the realm of investing and entered the arena of gambling (speculation).

Large losses are forever. A 50 percent loss requires a doubling in value of the asset just to get back to even. Ask yourself, how often have you known an asset to double in value and in what time frame? It takes roughly seven years for an investment to double in value earning a 10% annual return. By avoiding large losses (play defense), the winnings will have every opportunity to take care of themselves. Manage your downside. Play good defense. Avoid big mistakes. In investing, as in sporting competition, learn to cut your losses (eliminate mistakes) and the winners will follow.

In an article published in the Financial Analysts Journal (1995), “The Loser’s Game,” Charles D. Ellis writes convincingly about the inability of professional money managers to “beat the market.”[1] He sites a study conducted by an eminent scientist, Dr. Simon Ramo of TRW.

Ellis writes, “Simon Ramo identified the crucial difference between the Winner’s Game and the Loser’s Game in his excellent book on playing strategy, Extraordinary Tennis for the Ordinary Tennis Player. Over a period of many years he observed that tennis was not one game but two. One game of tennis is played by professionals and a very few gifted amateurs; the other is played by all the rest of us.

After extensive scientific and statistical analysis, Dr. Ramo summed up his findings this way: Professional tennis players win points; amateurs lose points. Errors are seldom made by professional players. Expert tennis is what Ellis calls a Winner’s Game because the ultimate outcome is determined by the actions of the winner. On the other hand, the amateur duffer seldom beats his opponent, but he beats himself all the time. The victor in this game gets a higher score than the opponent, but he gets that higher score because his opponent is losing even more points. Professional tennis is a Winner’s Game - the final outcome is determined by the activities of the winner - and amateur tennis is a Loser’s Game - the final outcome is determined by the activities of the loser.

The ordinary player can win games and matches again and again by following the simple strategem of losing less, and letting the opponent defeat himself. The way to avoid mistakes is to be conservative and keep the ball in play, letting the other fellow have plenty of room in which to blunder his way to defeat. An opponent who tries to win a losers game will try to beat you by winning, but he is not good enough to overcome the many inherent adversities of the game itself. The situation does not allow him to win with an activist strategy and he will instead lose.”

This unfortunately is the same situation you face as an investor. In the long-run, you can not win with an activist strategy (market timing/security selection). Sure, every once in a while you will play a “hunch” and be rewarded, but this will only foster a false sense of confidence in your ability to repeat your good fortune. That is a trap and will come back to haunt you. In time your efforts to “win” will only increase your error rate. Over time you will start to underperform the market. This is how the ordinary investor loses in the Loser’s Game. According to Ellis, Ramo instructs in his book, the strategy for winning the Loser’s Game is to lose less. Avoid trying too hard (or in the case of the market, invest in an index fund that correlates well with the market and avoid trading, i.e. timing the market). In brief, as Ellis puts it, by losing less become the victor. If you can’t beat the market, you certainly should consider joining it. An index fund is one way.

Five Ways to Win the Loser’s Game:

1. Know Thy Self. What are your financial objectives? Are they achievable and realistic given your tolerance for risk? What is your risk tolerance? Can you stomach short-term fluctuations in wealth to achieve long-run investment success? Are you willing to put forth the work needed to be successful? Do you have the necessary skills and know-how to be a winning investor.




2. Define Your Long-Run Objectives: Set wealth goals. What are your financial needs? How much income will you need in retirement? Are you saving to provide for your children’s college education? Do you have the discipline and patience to pursue a long-run investment strategy? Plan the race that is right for you. Run your own race to achieve your own realistic objectives.




3. Do Not Try to Beat the Market: Forget about the notion of beating the market in the long-run. At best, you can hope to replicate the performance of the market. How do you expect to beat the market when it is made up of so many professionals? Professionals armed with vast resources. More resources than you can ever hope to have. Eventually, if you own enough stocks and hold a diversified portfolio, you will be the market, i.e. you can expect your portfolio to generate market returns. Oh yeah, every once in a while you will have a winner that makes you think you’re smarter than everyone else and that you can earn out-sized returns (get rich quick). Just remember, a baseball player with a .200 batting average will hit a home run every once in a while as well. That doesn’t mean he all of a sudden has acquired the skills to be a .350 hitter.




4. Diversification: Countless academicians and investment professionals have confirmed and endorsed the benefits of diversification (spread your risk over many bets; don’t put all your eggs in one basket). Stock portfolio (a portfolio made up of individual stocks) diversification can be achieved through the random selection of a number of stocks (usually 30 or more on an equally dollar weighted basis).The primary benefit of diversification is that for a given amount of risk, investors can expect to achieve a higher rate of return from an efficiently constructed portfolio (where the holdings in the portfolio are sufficiently uncorrelated). The basic concept that an investor can reduce portfolio risk simply by holding instruments which are not perfectly correlated (diversified) derives directly from the principles of Modern Portfolio Theory.




5. Have an Investment Policy: Investment policy (or more commonly, asset allocation - the division of investable funds among investable assets i.e. stocks, bonds, and cash) has been shown to account, on average, for 93.6% of the variation in total return in a sample of portfolios (corporate pension plans) studied.[2] In the past, criticism was directed at the study - or more accurately, its interpretation by the industry - and raised doubts about its applicability to general investors. Twenty years since being published debate continues over the importance portfolio policy (asset allocation) plays in the construction and subsequent performance of an individual’s set of investments. However, it would be hard to find any investment professional who would disagree with the notion that the initial decisions made regarding portfolio policy will play an important role in the outcome of any long-term investment strategy.

The market is dominated by institutional investors. Consequently, investing today is a Loser’s Game. You can’t win at investing by trying to “beat the market.” You simply must avoid losing.

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[1] “The Loser’s Game,” Charles D. Ellis, Financial Analyst Journal / January-February 1995: 95-100. Reprinted from FAJ (July/August 1975): 19-26.
[2]” Determinants of Portfolio Performance,” Gary P. Brinson, L. Randoph Hood and Gilbert P. Beebower, Financial Analysts Journal, (July/August 1986):39-44.

The opinions and views expressed in this article do not necessarily reflect the views of InvestingMinds.   InvestingMinds did not prepare and does not endorse such content.  Please note that this document is intended for general circulation only and the recommendations contained herein do not take into account the specific investment objectives, financial situation or particular needs of any particular person. This document is for information purposes only and it should not be regarded as an offer to sell or as a solicitation of an offer to buy securities or other financial instruments.  No part of this document may be reproduced in any manner without the written permission of InvestingMinds.

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.

The opinions and views expressed in this document do not necessarily reflect the views or opinions of InvestingMinds. InvestingMinds did not prepare and does not endorse such content. Please note that it is intended for general circulation only and the recommendations contained herein do not take into account the specific investment objectives, financial situation or particular needs of any particular person. This document is for information purposes only and it should not be regarded as an offer to sell or as a solicitation of an offer to buy securities or other instruments. No part of this document may be reproduced in any manner without the written permission of InvestingMinds.