Drip feeding cash into a share portfolio is a common way for investors to get started in the stock market. But it can also make a lot of sense for those with the benefit of a windfall or investing warchest at hand. Taking it slow and steady removes some of the fear of investing a lump sum at the wrong moment by spreading the risk over a longer period. However, some experts reckon that going “all in” is a risk worth taking because the long-term returns are almost always better. So which route should you take?
Why investors like Dollar Cost Averaging...
In the US, pumping funds into a portfolio at regular intervals is known as ‘Dollar Cost Averaging’ (DCA). It’s a popular tactic for many Americans who use it to invest a part of their monthly paycheck in their SIPP equivalent retirement accounts - the 401k. It’s also used by cautious investors who have a cash pile to buy shares but want to counter the risk of taking a massive hit should the market fall in the near future.
The logic for all this appears simple. Investing a fixed amount on a monthly or quarterly basis means buying more shares when the price is low and fewer shares when the price is higher. On paper, this keeps down the average price paid for a share.
...but academics aren’t so sure
But while the lure of low average prices has made cost averaging very popular among investors, some research shows that it doesn’t actually work too well. In fact, studies dating back to the late 1970s show that there are better ways of managing risk. For instance, US professor Michael Rozeff found that cautious investors could do better by simply lowering the fraction of funds invested in risky assets and investing them all at once.
Simon Hayley at Cass Business School has studied why cost averaging remains popular despite evidence that there are better strategies around. He thinks that it is recommended to investors without any detailed consideration of their goals, expectations or risk preferences, or the properties of the market involved. In a study on the topic, he noted: “...proponents almost invariably include a demonstration that Dollar Cost Averaging buys at below the average price, suggesting that it increases expected returns. This leads us to a much simpler theory: That investors use Dollar Cost Averaging because they mistakenly believe what…
