Response to Comments

I thought I'd respond to some of the comments in the main blog rather than limit all of the interesting discussion to the comments section.

Remco writes:

I think its purpose is exactly what its name implies, which is to purchase (or sell) stock at a short-term average price.... 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).

Two responses. First, I agree and have already pointed out that dollar-cost averaging does reduce risk as compared to a lump-sum investment. But the reason it reduces risk is because you are holding a lot of cash during the transition period, not because that gradual transitioning process has some variance-reducing power over and above that. My assertion is that if it is suboptimal (because too risky) for you to hold the entire amount in stocks, then the rational thing to do is to simply reduce the amount you move into stocks. In general, to control variance, reduce the amount you assign to the riskiest asset class; but always make a lump-sum shift into your target allocation. If you want to argue for dollar-cost averaging, you should argue not just that it reduces variance, but that it reduces variance in a way superior to the alternatives (e.g., simply continuing to hold some cash).

Second, I would assert that the only rational way to measure risk or return to compute them with respect to your whole portfolio. It's true that dollar-cost averaging will ensure that you don't buy the stock at a local minimum or maximum. Over a sufficiently short time period, it will also reduce the variance in your return on that stock over that period. But so what? What you should really care about is your overall net worth, and the variance on that. Imagine that you keep your money in your left pocket and your right pocket. It would be irrational to make decisions based solely on the returns and volatility of your "right pocket" money. My earlier posts lay out the argument why dollar-cost averaging has no value when looking at your portfolio overall.

Dollar-cost averaging is clearly marketed to people as something that would be beneficial to them. It's possible that those marketing it only directly point out that they are going to get a "fairer" price for the stock. But it's implicit that this matters, that this is beneficial to their overall financial situation.