Dollar-cost averaging vs. lump-sum investing(ZT)

Despite a plethora of academic literature against the strategy of dollar-cost averaging, many financial institutions and financial advisers continue to recommend this approach to their clients.

Why?

In a 2006 paper by John Greenhut entitled Mathematical Illusion: Why Dollar-Cost Averaging Does Not Work, the author deflates a common myth among financial advisers that throughout a stock market cycle, dollar-cost averaging outperforms a lump-sum investment strategy.

Dollar-cost averaging is the process of buying a fixed dollar amount of a particular investment on a regular basis, regardless of share price. Traditional thinking is that eventually the average cost a share will become smaller and smaller, thereby increasing one's performance over time.

I can see this working in a down market, but what about an up market? Wouldn't the average cost base increase with a rising market?

Moreover, if the market rises roughly 70 per cent of the time on an annual basis, wouldn't a lump-sum investment do better than a dollar-cost averaging approach that continues to buy into an escalating market?

Greenhut demonstrates that beyond the psychological appeal of dollar-cost averaging, the popularity of the approach stems from overly simplistic illustrations that show dollar-cost averaging resulting in greater stock holdings than that which is achieved by a one-time, lump-sum investment.

"The performance of dollar-cost averaging rests on the trend in stock prices, dollar-cost averaging outperforming in downward markets and lump sum outperforming in upward markets," says Greenhut.

Since the market rises more often than it falls, this finding helps to explain the under performance of dollar-cost averaging in academic studies throughout a stock market cycle.

Why is there conflicting academic research on the benefits of dollar-cost averaging versus lump-sum investing?

According to Greenhut, the primary reason is whether the market is in an uptrend or downtrend. Studies that focus on downward trending markets will produce favourable results for dollar-cost averaging, while upward trending studies will not.

Studying the process throughout a complete stock market cycle is the best approach and one that will yield a neutral to negative result for dollar-cost averaging versus lump-sum investing.

Despite its shortcomings with respect to outperforming a lump-sum investment strategy throughout a real life stock market cycle, dollar-cost averaging is not completely without merit.

Dollar-cost averaging helps to mitigate the pressure of market-timing for many investors. The benefit here is mostly psychological, as Greenhut acknowledges, and speaks to the issue of managing risk and timing more so than it equates to out performance.

Wall Street's most successful traders will tell you that one of the surest ways to go broke is averaging down on a losing position. You may get lucky from time to time, but do it often enough and odds are you will be sorry.

Dollar-cost averaging is a time-honored investment strategy whose efficacy for practical reasons has been misrepresented. There are some benefits to dollar-cost averaging, but out performance by reducing the cost base of an investment throughout a stock market cycle proves not to be one of them.

If you have the choice of making a lump-sum investment or dollar-cost averaging your way into the market, without consideration for market trends or market timing, the lump-sum method seems to be the better option.

Thanks go to Greenhut for debunking yet another common investment fallacy that will shock many investment professionals.

For a link to Greenhut's article, please visit the Links section of my website at www.neilmurray.ca.

Neil Murray is an investment adviser with BMO Nesbitt Burns Inc. in London. Reach him at 519-646-2313 or e-mail [e-mail]. Opinions are those of the author and may not reflect those of BMO Nesbitt Burns. The information and opinions contained herein have been compiled from sources believed reliable but no representation or warranty, express or implied, is made to their accuracy or completeness. BMO Nesbitt Burns is a member CIPF.