Investment Averaging

Abstract

As individuals go through life earning income they invest, they implicitly engage in dollar cost averaging (with the same investment they buy more when prices are low, and less when prices are high). They rebalance their stock-bond mix periodically, by selling appreciated assets, or buying more of depreciated assets. They do all of this on autopilot. They are told not to try to time the market. Instead, life and rigid rules dictate the timing of their investment. Does this passive behavior increase the risk that they will miss their retirement targets? The author concludes that just the opposite may actually occur. He shows that while the purported cost advantage of dollar cost averaging for a long-term investor is doubtful (asset prices increase over time, so delaying investment is costly), the reduction of investment risk is not. By investing smoothly over time rather than in large discrete chunks (or once up front), investors reduce not only the standard deviation of the terminal value of their investment upon retirement, but also the expected amount by which they may fall short in case they miss their retirement goal. The author argues that the latter measure is a much better metric of risk than the standard deviation or beta of a stock or portfolio.