You would naturally think that financial markets were hotbeds of rationalism and hard headedness. That only ideas that actually worked would be taken seriously. If you are of this opinion you are in for nasty shock. Any funds under management you have are being managed by people who believe that the best time to buy a share is when it is falling, the best time to sell a share is when it is going up and who have not the faintest idea nor interest in the more practical applications of money management.
Occasionally I see some of the material that the more high end quant driven hedge funds produce or read about traders who use trend following as their prime driver and I think there might be hope. But then I have to do something like professional development. When you operate under an AFSL such development is mandatory and that’s probably not a bad thing if it were not for the quality of the material presented as being professional.
Recently (read yesterday) I was going through some of the material and surprise surprise it advocated averaging down as a technique that could be employed successfully…….yeah in what friggen universe. I am always staggered that people cling to outmoded notions when there is absolutely no evidence to support and large amounts to refute them. You can stick averaging down in the same category as flat earth believers, homeopathy, crystals, psychics and UFO’s. It has about the same intellectual weight as a women’s magazine.
DCA seems, like many market myths, to be a logical mechanism of investing – the investment of regular sums of money at regular intervals would appear to be a strategy that would mean a lower than average entry price and a minimization of volatility. A quick scan of Google shows it to be a universally extolled strategy – you can make the conclusion from this that stupidity is universal and that we are at the high watermark of our development and it is all downhill from here..
References to DCA go back to about 1925 when Robert Montgomery in his Financial Handbook (Roland Press 1925) urged investors to undertake a “diversification of maturity” strategy, because “the constant reinvestment of funds places one in a position always to take advantage of such price opportunities as arise.”
This notion took hold in the financial community with little or no challenge. Some rigor was applied to the concept in 1967 when Cohen, Zinbarg, and Zeikel in Investment Analysis and Portfolio Management (Richard D. Irwin, 1967) observed that “Dollar-cost averaging allows one to buy a greater number of shares of any stock when the price is down. Dollar-cost averaging is most helpful in buying growth stocks.”
This concept seemed logical and it seemed as if both references were correct. It seemed intuitively correct that DCA provided a lower average entry price, a hedge against volatility and therefore a more stable return to the investor. However, intuition is a poor yardstick by which to judge matters of money. After all it seems intuitively correct that it is not a loss until you sell or that you can never go broke taking a profit. Unfortunately intuition is wrong on both of these counts and it is wrong regarding DCA.
The first serious work on DCA was done in 1979 by George Constantinides whilst at the University of Chicago. In the formal language of academia his paper was titled – A Note On The SubOptimality Of Dollar Cost Averaging As An Investment Policy.This is a rather formal way of saying it doesn’t work and is inferior to lump sum investing. Curious as to how inferior it was I decided to do a bit of investigating by looking at returns on the S&P500 dating back to Jan 1928. The S&P500 was chosen because of the availability of a continuous data.
Here comes the Kick…
In this little study I looked at a sequential series of investments into the S&P500 versus a single lump sum investment at the beginning of each year. Grinding through 1000 iterations I found that lump sum investing wins on an end of year valuation 66.9% of the time. My rather crude eyeballing of the results show that the disparity between the two strategies was even worse when the market was running. So the question becomes “do you want to be involved in a strategy that only has the potential to be of benefit to you 33.1% of the time?” And do you want to cling dogmatically to this approach despite evidence to its lack of effectiveness.
John Knight and Lewis Mandell in Financial Services Review 2.(1) 51-61 did a much more detailed analysis of DCA than my basic hack job. They compared DCA to traditional buy and hold and what they termed dynamically rebalanced portfolios or actively traded portfolios. They analysed these approaches across a series of investor profiles starting with a high degree of risk aversion and working their way to a low degree of risk aversion. In each instance DCA underperformed the alternatives.
Their summary is extremely telling and very well expressed:
“Brokerage firms promote Dollar Cost Averaging primarily with two rationales. First, they argue that returns are augmented because more shares are purchased when prices are low and fewer when prices are high. Second, they assert that Dollar Cost Averaging enhances investor utility by preventing an ill-timed lump sum investment. Our results do no support either of these contentions.”
In conclusion they state:
“Using three separate methods of comparison, we have shown the lack of any advantage of Dollar Cost Averaging relative to two alternative investment strategies. Our numerical simulations and empirical evidence, in consonance with our graphical analysis, both favour the Optimal Rebalancing and Buy and Hold strategies over Dollar Cost Averaging.
“Optimal Rebalancing and Buy and Hold strategies convincingly outperform Dollar Cost Averaging on theoretical grounds a well as on the basis of numerical simulations. Historical evidence also supports these two strategies, though the empirical differences are not significant.
“Our results strongly imply that the additional cost and effort associated with Dollar Cost Averaging cannot be justified for any investor, regardless of degree of risk aversion. With the possible exception of its promoters, nobody gains from Dollar Cost Averaging.”
This raises the question that if DCA is a discredited idea, why do people hang on to it? Part of the answer undoubtedly lies in that the people involved in financial markets and the provision of financial advice are by and large remarkably ill informed about the nature of the business world they operate in. It is easier to give answers that seem intuitively correct rather than to critically evaluate matters.
There is also probably an element of ego defensiveness involved. It is embarrassing to have to revise your point of view – it is even worse to have to do it in public. We act at all times to preserve our ego. However, you need to ask yourself how valuable your ego is and how much are you willing to allow your ego to cost you before you do some serious thinking?