Dollar-Cost Averaging

I saw a post today on bogleheads.org where the poster was asking whether he should engage in dollar-cost averaging. I've always felt dollar-cost averaging is basically a bunch of baloney (well, under certain reasonable assumptions anyhow), but I didn't feel like attempting to write up a long explanation, in part because I find my argument a little hard to articulate in a convincing fashion. But when I searched on the web, I was unable to find a really good explanation of why dollar-cost averaging is bogus. There were various articles from the popular press that alluded to the fact that many academics find the concept without merit. But no really good write-up from the academics themselves (that I could find). Hence, my own feeble attempt herewith.

For those who aren't familiar with the concept, the scenario where dollar-cost averaging comes into play is when you have some lump sum to invest. To be concrete, let's say you have $100,000 to invest, and you've decided the optimal thing is to put it all in stocks eventually. We can assume you are holding it in your bank account at the moment while you decide what to do. The question you are faced with is whether to simply invest the $100,000 in stocks now, or perhaps invest $10,000 per month over the next ten months. That second approach, where you shift the money gradually into stocks, is dollar-cost averaging.

Intuitively, dollar-cost averaging may seem appealing. Putting the full $100K into stocks overnight may seem dangerous. You may think - what if the stock market crashes tomorrow? I'll be pretty sorry then. Wouldn't it be safer to shift the money over gradually?

Here's a better way to think about it. Let's say that we have some way to quantify the risk of a particular portfolio. For example, it could be the standard deviation of the distribution of annual returns for your portfolio based on certain assumptions about the expected returns and expected volatility of individual asset classes. But it doesn't really matter what method you use. What's important is that that risk value - let's call it R - is just a function of the assets you hold in your portfolio. In particular, your risk today is not a function of what you held yesterday. This should be obvious.

Part of the premise of our story is that the investor has weighted the risks and opportunities of different possible portfolios and has decided that the best allocation, the one he wants to get to eventually (at least) is the one that involves moving the full $100K into stocks. He's decided that the risk R he will face with that portfolio is acceptable, given the expected returns that portfolio offers.

So what's the point? The point is that if the investor has decided he can tolerate a risk of R, then he might as well shift his assets immediately to form that portfolio. The risk he will be taking is precisely R - no more and no less. If one day ago he had 90% of this $100K in stocks, or 0% of this $100K in stocks, it doesn't matter. The risk he is taking is still R.

So am I arguing that dollar-cost averaging is not safer? No, not at all. Since the money is currently in cash, moving the money gradually from cash to stocks over a ten-month period results in a safer (less volatile) portfolio for that ten-month period. But, by supposition, the investor has decided that the money should eventually all be in stocks. So having less in stocks is suboptimal in that it gives up to much return to justify the reduction in risk. If that's true ten months from now, it's true tomorrow.

Now, of course, you can argue that putting all that money in stocks might not be the right thing. Perhaps that's too risky. But that's not an argument for dollar-cost averaging. You're really questioning the premise of our story, and arguing that this investor shouldn't move the full $100K to stocks.

One key assumption I've made is that this investor has no foreknowledge of where the market is going. If you knew that stocks were going to be very volatile in the short term, but their excess-of-normal volatility was going to decrease and go away over the next ten months, then you could probably make a case for dollar-cost averaging. But I don't think investors in general have this sort of knowledge, and anyhow this sort of assumption is not part of the typical arguments for dollar-cost averaging.

First Post

I'm hoping to use this blog to post some of my thoughts on financial matters. I will be interested in any and all comments.