Thursday, August 11, 2005

Dollar Cost Averaging passes the test!

In Dollar Cost Averaging Brennan, Li, and Torous presents evidence that dollar cost averaging (investing equal amounts whether the market is up or down) actually works! In their words:
"evidence supports the view that the individual investors who follow this strategy in purchasing individual stocks to add to an existing portfolio are better off than if they followed the 'rational' strategies traditionally recommended by academics"
The short version of the paper is that while dollar cost averaging (DCA) may offer lower returns, it also lowers the risk. Consequentally, it seems that it does have an important roll to play in finance.

Again in their own words:
"We find, first, that, for an investor who is purchasing a diversified investment portfolio of common stocks represented by the CRSP value-weighted or equal-weighted indices, the DCA strategy, carried out over implementation periods of from one to six years, outperforms the lump sum investment strategy for all except the most risk tolerant investors. This seems to be due to the lower level ofrisk associated with the DCA strategy."
Yet another reason to use automatic investment plans!

As an aside, I love the paper's introduction:
"Practical or tacit knowledge typically precedes scientific knowledge. Crops were rotated long before the chemical basis of the practice was understood. Men learned to fly before aeronautics was well understood. Extracts of willow were described by Hippocrates as a pain remedy well before Bayer first synthesized aspirin....Therefore, given the relatively brief period of scientific study of financial markets, and the controversy that surrounds the interpretation of many of the findings, it is not surprising to find that a good deal of financial practice is stillgoverned by pre-scientific heuristics or maxims"

Michael J. Brennan, Feifei Li, and Walt Torous, "Dollar Cost Averaging" (June 24, 2005). Finance. Paper 17-05.