I want to back up and try to restate my argument against dollar-cost averaging, and maybe make it a tad more explicit in the process. My original post didn't spell out a lot of the assumptions I was making.
The central point of my argument against dollar-cost averaging is that the (expected) risk-adjusted return of a portfolio is time-invariant. (Although I don't actually quite believe that - see below.) Implicitly, I am using "risk-adjusted return" as an overall goodness measure of a portfolio. In other words, your only objective as an investor is to select a portfolio that maximizes the risk-adjusted return. Once we accept that your risk-adjusted return is time-invariant, then it follows immediately that dollar-cost averaging is irrational, because dollar-cost averaging is a specific way of varying your portfolio over time which is alleged to be beneficial.
So what exactly is "risk-adjusted return"? Well, different people might define it in different ways. Obviously the expected return of the portfolio should play a role. (For example, a portfolio with an expected annual return of 10% would be preferable, all other things being equal, to a portfolio with an expected annual return of 5%.) Additionally, most people would agree that some measure of risk or volatility should contribute. Given a choice between a portfolio that always yields exactly 10% annually, and one that has an expected return of 10% but may be much higher or lower, it is natural to assume that a rational investor would choose the former. How do you measure risk or volatility? Typically people use the standard deviation of the return, but you could probably use a different measure without affecting the present argument. How do we combine the expected return of the portfolio with the risk measure (e.g., standard deviation)? Again, different people will do it differently and it ultimately may not matter for our purposes. But, for concreteness, we could use the Sharpe ratio.
Why then should we believe that risk-adjusted return is time-invariant? Well, there are good theoretical reasons to believe that expected returns are time-invariant, stemming from the idea that markets are reasonably efficient. Suppose expected returns were not time-invariant; in other words, we have reason to believe that the returns of some asset class will be higher or lower at some point in the future than the expected return over the long run. Well, we would presumably take advantage of that fact. For example, if we thought stocks were about to perform poorly in the near future we would sell them today; if we thought they were about to shoot up, we would buy them. Furthermore, the market is full of smart people looking for any edge; it would be unrealistic to expect ourselves to be the only people with this information. Enough people trying to exploit this "mispricing" will force prices down to their "true" value. So, contrary to assumption, in an efficient market we do not expect there to be mispricings of this sort. Or, at least, we do not expect them to be large and we do not expect them to persist long enough for an amateur investor to take advantage of.
Unfortunately, I don't think there are similar arguments that expected volatility must be time-invariant. As I write this in October of 2008, we are in the middle of one of the biggest market crashes of the century. I do not know whether the market will move up or down over the next few weeks, but I do have good reason to believe that volatility will be unusually high. Knowledge about future volatility cannot be arbitraged away (it seems to me), so there is no reason for it not to exist.
Still, this doesn't really constitute an argument for dollar-cost averaging. I can see some grounds for making some adjustments (probably minor) to your portfolio over time depending on your expectations of future volatility. But, as I mentioned in my original post, the kind of gradual portfolio shift entailed by dollar-cost averaging, would only be sensible in the highly unusual circumstance where you have information that volatility will be high in the near future, but will gradually decrease over time.
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I think that we both have a different idea of what the purpose of dollar cost averaging is. I think its purpose is exactly what its name implies, which is to purchase (or sell) stock at a short-term average price. There are only two time points that are relevant: the day you purchase stock and the day you sell it. What happens in between is irrelevant. Dollar cost averaging tries to makes sure you get a "fair" price, i.e., that you don't buy stock at a local maximum or sell it at a local minimum. What you get is a reduction in risk (clearly), at the expense of reduced returns (because stock goes up on average and hence you end up paying more / getting less, on average). The question is, what happens to the trade-off (e.g., sharpe ratio)? Try it out, simulate it using actual stock data. I have.
Or here is another perspective: the stock market is a noisy line that goes up over time (just take a look at a chart of the Dow Jones for the last 50 years). You want to get rid of the noise and take advantage of the going up part only. Hence, what you do is filter the curve.
Note that I'm assuming long term (10+ years) buy-and-hold strategies of index funds.
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