With the market sinking in 2020 and the subsequent recovery, now is a good time to reconsider the dollar-cost averaging (DCA) argument for investment.
Benjamin Graham popularized DCA in his first 1949 book Intelligent investmentAnd he writes:
“Dollar-cost average [ . . . ] This simply means that practitioners invest the same number of dollars per month or quarterly in common stocks. Thus he buys more shares when the market is low and his price is high and he can end up with a satisfactory overall price for all his holdings.
DCA is an effective strategy when customers are saving or investing single money. Over the years of client savings, DCA adds discipline to the process. When clients invest in a brokerage account each month, for example, DCA calls behavioral economists self-regulation bias, or reduces the tendency to eat today at the expense of tomorrow’s savings. And mathematically, DCA means money starts to compound earlier.
Outside of brokerage accounts, DCA employer-sponsor 401 (k) accounts and dividends work well with reinvestment plans (DRIPs), whereas, a company pays a large dividend but the client does not need immediate income.
The advantages of DCA when allocating a single amount are not so obvious. But clients can reduce the investment risk of earning from pension payments, inheritance, selling a business, easy account transfers, etc., with a DCA approach instead of investing it all at once.
By comparing the Historical Returns, we have determined how much risk the DCA can reduce. We have examined the index portfolio for stocks, bonds and 60/40 blends throughout the rolling period since 1990. The deadline is more than a monthly installment of more than a year as most clients will find the latter extraordinary. Moreover, the longer the deadline, the more the asset mix will deviate from the goal, and clients who need investment income to retire do not want to wait a whole year to allocate all income.
Our results fall into the following chart:
Immediate vs. DCA investment
The colored columns show the difference in return between instantaneous and DCA. Orange squares refer to when the instantaneous method works better, green when DCA is preferred and yellow when instantly better.
Consecutive patterns emerge across the three resource divisions and throughout the rolling period. The investment immediately generates a higher average rolling return than the DCA when the belt increases while the length of the rolling period increases. Compounded without any compound drug before high return. Frequencies that instantly exceed DCA also increase in the long term frame.
So what are the benefits of DCA for negative risk?
Instability, or value deviation, decreases with DCA and increases with time. The advantages of DCA are particularly evident with the lower decimal and worst returns, which follow a similar pattern. The average rolling return / volatility ratio is small but imperfectly good for immediate investment. Of course, since these are short-term return rolling, the risk-free rate will be lower and more precise sharp ratios will follow the same pattern. So immediate investment usually produces higher returns, but with more risk, especially in the negative.
Most clients will appreciate the low risk of DCA. All investors are remorseful for the negative bias of remorse and loss, or, respectively, the tendency to avoid action due to fear will turn out to be bad and will suffer losses more strongly than profits. In fact, the potential for loss is twice as strong as the potential for gain. These emotions probably spread with plenty of fresh cash for retirees.
In fact, DCA offers the most benefits to retirees and retirees. First, retired clients rely heavily on investment income and creating that income will be their first priority. Second, DCA is a hedge against the order of return risk, or the possibility of large losses early in retirement. Such losses “bite” from a portfolio are as big as ever. DCA can reduce the risk of such results. On the chart, the four-week worst rolling return for the 60/40 portfolio in the last 30 years was -24.1% in March 2020. And by actively selecting the most attractive stocks and bonds, those negative risks can be further reduced.
In short, DCA’s wisdom is time-tested. DCA has a wide range of applications for all types of clients, but especially for those close to or near retirement and for whom income-generating is a higher priority. For a single investment, our analysis demonstrates its usefulness as a risk reduction strategy.
And finally, lest we forget, DCA was good enough for Ben Graham. So who are we to argue?
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All posts are the author’s opinion. As such, they should not be construed as investment advice, or the opinions expressed must not reflect the views of the CFA Institute or the author’s employer.
Wealth Enhancement Advisory Services, LLC, a registered investment advisor and affiliate advisory service of Wealth Enhancement Group. Wealth Enhancement Group is a registered trademark of Wealth Enhancement Group, LLC.
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