Dollar cost averaging

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Dollar cost averaging (DCA) is an investment strategy for reducing the impact of volatility on large purchases of financial assets such as equities. By dividing the total sum to be invested in the market (eg $100,000) into equal amounts put into the market at regular intervals (eg $1000 over 100 weeks), 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 minimizes downside risk.

In essence, the technique works in markets undergoing temporary declines because it exposes only part of the total sum to the decline. The technique is so-called because of its potential for reducing the average cost of shares bought. As the amount of shares that can be bought for a fixed amount of money varies inversely with their price, DCA effectively leads to more shares being purchased when their price is low and fewer when they are expensive. As a result, DCA can lower the total average cost per share of the investment, giving the investor a lower overall cost for the shares purchased over time.[1]

Dollar cost averaging is also called the constant dollar plan (in the US), pound-cost averaging (in the UK), and, irrespective of currency, as unit cost averaging or the cost average effect.[2]

Parameters[edit]

In dollar cost averaging, the investor decides on two parameters: the fixed amount of money invested each time, and the time horizon over which all of the investments are made. With a shorter time horizon, the strategy behaves more like lump sum investing. One study has found that the best time horizons when investing in the stock market in terms of balancing return and risk have been 6 or 12 months.[3]

One key component to maximizing profits is to include the strategy of buying during a downtrending market, using a scaled formula to buy more as the price falls. Then, as the trend shifts to a higher priced market, use a scaled plan to sell. Using this strategy, one can profit from the relationship between the value of a currency and a commodity or stock.[citation needed]

Return[edit]

Assuming that the same amount of money is invested each time, the return from dollar cost averaging on the total money invested is[4]

r = \frac{p_F}{\tilde{p}_P} - 1,

where p_F is the final price of the investment and \tilde{p}_P is the harmonic mean of the purchase prices. If the time between purchases is small compared to the investment period, then \tilde{p}_P can be estimated by the harmonic mean of all the prices within the purchase period.

Criticism[edit]

The pros and cons of DCA have long been a subject for debate among both commercial and academic specialists in investment strategies.[5] While some financial advisors such as Suze Orman [6] claim that DCA reduces exposure to certain forms of financial risk associated with making a single large purchase, others such as Timothy Middleton claim DCA is nothing more than a marketing gimmick and not a sound investment strategy.[7] The financial cost and benefit of DCA have also been examined in many studies using real market data.[8][9][10]

Recent research has highlighted the behavioural economic aspects of DCA, which allows investors to make a trade-off between the regret caused by not making the most of a rising market and that caused by investing into a falling market, which are known to be asymmetric.[11] Middleton claims that DCA helps investors to enter the market, investing more over time than they might otherwise be willing to do all at once. Others supporting the strategy suggest the aim of DCA is to invest a set amount; the same amount you would have had you invested a lump sum.[12]

Confusion[edit]

Discussions of the problems with DCA can do a disservice to investors who confuse DCA with continuous, automatic investing. This confusion of terms is perpetuated by some articles (AARP,[13] Motley Fool[14]) and specifically noted by others (Vanguard[15]). The argued weakness of DCA arises in the context of having the option to invest a lump sum, but choosing to use DCA instead. If the market is expected to trend upwards over time,[16] DCA can conversely be expected to face a statistical headwind: the investor is choosing to invest at a future time rather than today, even though future prices are expected to be higher. But most individual investors, especially in the context of retirement investing, never face a choice between lump sum investing and DCA investing with a significant amount of money. The disservice arises when these investors take the criticisms of DCA to mean that timing the market is better than continuously and automatically investing a portion of their income as they earn it. For example, stopping one's retirement investment contributions during a declining market on account of the argued weaknesses of DCA would indicate a misunderstanding of those arguments.

The weakness of DCA investing applies when considering the investment of a large lump sum, and DCA would postpone investing most of that sum until later dates. Given that the historical market value of a balanced portfolio has increased over time, starting today tends to be better than waiting until tomorrow. However, for the average retirement investor's situation where only small sums are available at any given time, the historical market trend would support a policy of continuous, automatic investing without regard to market direction.

References[edit]

  1. ^ Chartered Retirement Planning Counselor Professional Designation Program, College for Financial Planners, Volume 9, page 64
  2. ^ "Durchschnittskosteneffekt". Retrieved 2009-01-12. 
  3. ^ Jones, Bill. "Do Not Dollar-Cost-Average for More than Twelve Months". Retrieved 2009-01-05. 
  4. ^ "Derivation of the dollar cost averaging return formula". Retrieved 2009-01-05. [dead link]
  5. ^ Explaining the riddle of dollar cost averaging Hayley, S Cass Business School report 2010
  6. ^ http://www.suzeorman.com/dt/calc_dollarcostaverage1.cfm
  7. ^ Middleton, Timothy (2005-01-04). "The costly myth of dollar-cost averaging". Retrieved 2009-01-05. 
  8. ^ Knight, J.R. and Mandell, L. Nobody Gains From Dollar Cost Averaging: Analytical, Numerical And Empirical Results. Financial Services Review, Vol. 2, Issue 1 (1992/93 pp. 51-61
  9. ^ Greenhut, J.G. Mathematical Illusion: Why Dollar-Cost Averaging Does Not Work. Journal of Financial Planning, Vol. 19, Issue 10 (October 2006), pp. 76-83
  10. ^ Constantinides, G.M. A Note on the Suboptimality of Dollar-Cost Averaging as an Investment Policy. The Journal of Financial and Quantitative Analysis, Vol. 14, No. 2 (Jun., 1979), pp. 443-450
  11. ^ [1] University of Buffalo report
  12. ^ "Dollar Cost Averaging: A Technique that Drastically Reduces Market Risk". Retrieved 2009-03-22. 
  13. ^ "The hidden benefit of an automatic investing program". Retrieved 2009-05-02. 
  14. ^ "Don't Make a Million-Dollar Mistake". Retrieved 2009-05-02. 
  15. ^ "Dollar-cost averaging just means taking risk later". p. 4. Retrieved 2013-01-28. 
  16. ^ "Long Term Returns (a survey of studies)". Retrieved 2011-03-13.