Analysis reveals time-honoured investing approach still has much to offer investors, especially with 2020 in mind
In an age where anyone can chase the high of instant gains from winning trades on digital investment platforms, the idea of making regular investments over time regardless of market performance might seem almost quaint. But there’s a reason why dollar-cost averaging (DCA), the approach popularized by Benjamin Graham, is considered a classic rather than a relic.
“During a client’s accumulation years, DCA adds discipline to the process,” Brian F. Lomax, CFA, CAIA, wrote in a blog post published by the CFA Institute.
In the context of brokerage accounts, Lomax pointed to the utility of DCA in mitigating self-control bias, which behavioural economists recognize as people’s propensity for immediate consumption at the expense of saving for the future. And when investors receive a windfall like an inheritance or business sale, he said using a DCA approach can help them lower the downside risk of investing the proceeds.
To determine DCA’s downside risk mitigation potential, Lomax compared how three different index portfolios – stocks, bonds, and 60/40 portfolio mixes – would have performed across rolling time periods since 1990 if a lump sum had been invested immediately versus investing it in tranches.
“For the DCA period, we assumed the lump sum was invested on a weekly basis over one, three, and six months,” he said, noting that longer time frames would cause the portfolio asset mix to stray from its target. Clients who depend on investment income in retirement, he added, would not be able to wait a whole year to allocate all the proceeds.
Across the three asset portfolio mixes and different rolling time periods, Lomax said that immediate investment consistently generates higher average rolling returns than DCA, with delta increasing as the rolling periods get longer. The higher returns, he said, stem from compounding earlier with no cash drag, and immediate investment wins out over DCA more often as the rolling period considered gets longer.
However, Lomax noted that volatility of returns decreases with DCA, and the degree by which it lowers volatility compared to immediate investment grows with time. That benefit of DCA is immediately apparent, he added, when considering the bottom-decile and worst returns for the different investment approaches.
“Of course, since these are rolling returns over short periods, risk free rates will be low and the more precise Sharpe ratio will follow a similar pattern. So immediate investing generally produces higher returns, but with more risk, especially on the downside,” he said.
From a behavioural perspective, Lomax noted that most clients will recognize the benefit of lower risks from DCA, particularly given the universally outsized tendency toward regret and loss aversion biases among investors. Retirees and near-retirees with large sums of fresh cash, he added, are likely to exhibit these impulses more distinctly: retired clients put a large premium on generating investment income, while those approaching retirement would take care to hedge against sequence of returns risk.
“[T]he worst four-week rolling return for a 60/40 portfolio over the last 30 years was -24.1% in March 2020. A DCA approach would have reduced that loss to -18.7%,” he said. “And by actively selecting the most attractive stocks and bonds, that downside risk could be mitigated even further.”
