Dollar Cost Averaging
For many investors dollar cost averaging has traditionally been the basis on which they invest. For example, this is how pension investment largely works. Rather than investing in one lump sum the investor invests smaller, regular amounts from their paycheque over a longer period of time. The idea is that by buying securities at predetermined intervals and in set amounts that this will reduce the risk of exposure to significant market declines. That is the theory and for many of us it intuitively feels right but does it actually work in practice?
In July 2012 Vanguard – the index fund pioneers – decided to look at the maths and published research comparing the historical performance of dollar cost averaging in three markets: the United States, Australia and the UK. The US data was based on studying rolling 10-year periods from 1926 to 2011. Their study found that on average the lump-sum approach would have outperformed dollar-cost averaging about two thirds of the time. They found that whilst dollar cost averaging minimises downside risk it also introduces other risks such as the potential for lower returns due to a temporary portfolio allocation to cash. The white paper can be seen at Vanguard’s website.
Despite this evidence, for many people this is a peace of mind issue about minimising regret and they are prepared to sacrifice returns to avoid the gut wrenching feeling of investing in one lump sum ahead of a double digit market decline.
As Vanguard state in their conclusion it is for the investor to determine whether the pursuit of returns or the reduction of short-term downside risk and the potential for regret is their main priority.
Head of MASECO Institutional