The Case against Dollar Cost Averaging October 18, 2010

Charles J. Higgins, PhD Dept. Finance/CIS Loyola Marymount Univ. 1 LMU Dr. Los Angeles, CA 90045-8385 310 338 7344 chiggins@lmu.edu

Introduction Dollar Cost Averaging (DCA) has been touted as advantageous as an investment tool.1 DCA is the acquisition of securities where more (or less) of a security are purchased as the security price falls (or rises), or 1) Qt = A/Pt

where A is a periodic payment in a portfolio to purchase a security and Qt is the number of shares of a security purchased at time t given security price Pt at time t. The value of the portfolio VT at the terminal time T would be: 2) VT = PT Qt .

It is argued that because relatively more shares are purchased at lower prices than at higher prices then DCA produces superior investment returns. The argument typically uses an example like: assume quarterly payments toward retirement of say $120 and quarterly security prices of say $10, $12, $8, then $10 and the number of shares purchased respectively would be 12, 10, 15, then 12. This averages out to 49/4 or 12.25 instead of say 12 had the price remained at $10 for all periods. Had the sequence of prices been different (say $12, $10, $8, then $10), but with the terminal price unchanged, the result would be the same. Critique It can be shown that DCA does not produce superior returns for two separate reasons. First, most investors have no other relevant or feasible choice. That is, regular payments to a portfolio (as is typical for retirement accounts) are usually in constant dollar amounts with the number of shares acquired at each period being that as described herein and it would be difficult to do otherwise. Moreover, mutual funds purchases are in dollar amounts (not in number of shares) while instead mutual fund sales are indeed in number of shares.

The second and more telling critique of DCA is to examine whether it would indeed produce superior results. That is, does the terminal portfolio value increase as the interim security price Pt increases its variation? The security price is properly determined by
3)

Pt = Pt-1(1+s)

where s is the standard deviation of normal random return and

4)

= -log(1)1/2sin(2 2)

where 1 and 2 are independent uniform random variables U(0,1). Results A simulation with 10,000 runs across 40 periods with an annual standard deviation of zero for with a mean zero return and an annual investment payment of $100 and an initial security price Po of $100 (which in this simulation did not vary) produced a terminal value of $4,000 with a terminal accumulated share total of 40 as would be expected. An otherwise similar simulation with an annual standard deviation of . 1 with a mean zero return produced a terminal value of $4,000 as would be expected, but with some accumulated 44.436 shares. True, the expected terminal price PT is $100 but is no longer symmetrically distributed at time T (note that the terminal price is unbounded upward, but is bounded by zero downward). Another simulation with an annual mean of .04, or Pt = Pt-1(1.04+s), produced an expected terminal price of $480.06 and $480.66 and expected terminal values of $9,502.75 and $9,502.15 for standard deviations of zero and .1 respectively. Properly, the terminal 40 year price should be $480.10 (100*1.0440). Simulations also considered scenarios wherein constant share purchases were made with cash surpluses (shortages) which were deposited to (withdrawn from) a separate certain (zero standard deviation) account with similar returns. These results, while similar and meant as a test of DCA as such, would be difficult to actualize in real world retirement portfolios. Results DCA is an investment process most portfolios do automatically and have little choice to do otherwise, and further does not produce excess returns. This simulation is in an addition to other critiques.2

References
1. See: Wikipedia, http://en.wikipedia.org/wiki/Dollar_cost_averaging Consumerism Commentary, http://www.consumerismcommentary.com/dollar-costaveraging/ Sigma Investing, http://www.sigmainvesting.com/advanced-investing-topics/dollarcost-averaging 2. See: Costly Myth of Dollar-Cost Averaging Money Central, http://moneycentral.msn.com/content/p104966.asp