Definitions

constant dollar

Dollar cost averaging

Dollar cost averaging — also known as a constant dollar plan or in the United Kingdom as pound-cost averaging — is an investing technique intended to reduce exposure to risk associated with making a single large purchase. The idea is simple: spend a fixed dollar amount at regular intervals (e.g., monthly) on a particular investment or portfolio/part of a portfolio, regardless of the share price. The premise of dollar cost averaging is that the investor wants to guard against the risk that the market may lose value shortly after making his investment. Therefore, he chooses to spread his investment over a number of periods.

Since the market has a positive mean rate of return, dollar cost averaging usually requires the investor to give up some expected return for the benefit of reduced variance in his eventual outcome. In fact, research has shown that investing a lump sum according to these principles generally results in worse performance as compared to investing the entire sum at separate times (Constantinides, 1979). However, the investor can expect a reduction in the variance of his performance by implementing dollar cost averaging. While dollar cost averaging can help to limit the downside of a worst-case scenario of an immediate drop in asset value after the lump sum is invested, most market research has shown that such drop-offs are relatively rare compared to the strong emphasis the strategy puts on avoiding them.

Investing horizon

When using dollar cost averaging, the investor must determine how long the investment horizon will be as well as the frequency of making investments (i.e.: monthly, quarterly, etc.). Again, the investor must generally balance the tradeoff between reduced variance and improved performance. By selecting a short time horizon, the strategy will behave more like lump sum investing with better performance but higher variance. With a long time horizon, dollar cost averaging has a greater chance of producing worse performance but the variance of returns will be reduced. One study has found that the best horizons when investing in the stock market have been 6 or 12 months (Jones, 1997).

Advanced techniques

When making the decision to dollar cost average, the investor can consider additional information about the investment which may guide his choice of strategy. For instance, when investing in the stock market, the investor can use the market’s P/E ratio as an indicator of the expected future rate of return. A high P/E may indicate that the expected future rate of return is lower than the historical rate (maybe even negative) and dollar cost averaging may be a superior strategy than lump sum investing. Research has shown that the choice of dollar cost averaging can actually produce superior performance and reduced variance in comparison to lump sum investing when the market’s P/E ratio is high (Sigma Investing, 2006).

Another formulaic investing strategy is called value averaging. In contrast to dollar cost averaging, this technique aims to invest an amount in each period such that a target investment value is achieved in each period. In some cases, value averaging will call on the investor to sell some of his asset if the target is surpassed. It is more complicated than basic dollar cost averaging but has been shown to produce superior results.

Reverse dollar cost averaging

Until now there has been nothing similar on the withdrawal side. In fact the common practice of withdrawing a constant sum each period is dollar cost averaging with you on the losing end. United States patent 7003483 has been issued for a method of reverse dollar cost averaging to sell for more, not less, than the average price.

Criticism from economists and finance experts

Dollar cost averaging has been widely criticized by economists and academic finance researchers as more of a marketing gimmick than a sound investment strategy (a way to gradually ease worried investors into a market, investing more over time than they might otherwise be willing to do all at once). Numerous studies of real market performance, models, and theoretical analysis of the strategy have shown that in addition to having the admitted lower overall returns, DCA does not even meaningfully reduce risk when compared to other strategies, even including a completely random investment strategy.

References

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