Q: I have read that when markets are volatile, a good way to reducing risk when investing is to use dollar cost averaging. How does this strategy work and what are its pros and cons?
A: Dollar cost averaging is the practice of building up investments gradually over time in equal amounts, rather than investing the planned amount all at once in a lump sum. It is widely recommended in popular investment guides but it has been subject to a lot of critical examination in academic literature.
You may have $100,000 to invest and you plan to put it into an equity fund. Instead of committing all the money at once, a dollar cost average strategy would involve putting in, say, $10,000 a month or every couple of months until the full amount is invest.
The investor has to decide on three parameters: the fixed amount of money invested each time; the investment frequency (monthly or quarterly), and the time horizon over which all of the investments are made (for example, 12 months or two years).
This is a form of diversification – time diversification. The idea is that if the market suffers a big fall while you are averaging in, you will not have all your money exposed to loss.
The main criticism is that a strategy that commits an investor to continue making periodic investments is inferior to a more flexible strategy that allows the investor to make use of new information that become available later.
Another criticism is that, while averaging may be seen as a useful form of diversification, returns that come when only a small amount is invested have little weight, and this offsets the diversification benefit.
Another issue is that as the investment horizon decreases, later investments have less time to offset earlier losses.
Behavioural finance is used to explain the popularity of averaging. Investing at a constant rate takes choice, and thereby regret, out of the equation. It also protects investors from their tendency to base investment decisions on naïve extrapolations of recent price trends.
However, human nature being what it is, investors using an averaging strategy may be tempted to try and time the market by suspending future averaging investments when the market is falling and resume when the market is rising.
Another criticism is that for certain types of securities (such as buying shares through an online broker) averaging will increase transaction costs, potentially negating much of the benefit from reducing risk.
One study concluded that for investors who are investing for a positive expected return, “those who hesitate lose money.” In other words, it makes more sense to put all the money in at once.