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For those unfamiliar with the term Dollar cost averaging (DCA)

is an investment strategy for reducing the impact of volatility on large purchases of financial assets such as equities. By dividing the total sum to be invested in the market (eg \$100,000) into equal amounts put into the market at regular intervals (eg \$1000 over 100 weeks), DCA reduces the risk of incurring a substantial loss resulting from investing the entire "lump sum" just before a fall in the market.

Dollar cost averaging appears to perform worse than lump sum investment. If this is the case, then why do a lot of people engage in dollar cost averaging instead of lump sump investment?

My own guess is that dollar cost averaging "allows you to sleep better" at night because the chances of making catastrophic losses are smaller than lump sum investments; in other words, loss aversion is at work here.

Am I right? In other words, I have two intertwined questions here

  1. Does dollar cost averaging have a lesser chance of blowing up?
  2. If yes, is this why people prefer it?
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    $\begingroup$ Just curious, if you have \$100,000 to invest and you are putting \$1000 into the market each week, where does a DCA investor put the remainder of their money (i.e., the \$99,000 in week 1, the \$98,000 in week 2, etc.). Surely the performance of that implicit investment is particularly relevant to evaluating the DCA strategy. $\endgroup$ – Jeromy Anglim♦ Mar 5 '14 at 7:12
  • $\begingroup$ @JeromyAnglim, usually the DCA investor will put it in a risk-free investment such as bank. It is on this basis that most frequently the performance of DAC and Lump Sum is compared $\endgroup$ – Graviton Mar 5 '14 at 7:16
  • $\begingroup$ I think you have a good hypothesis, which may be enormously difficult to test in practice, for at least three reasons. First of all, when the link states that DCA appears to underperform, that's presuming one is on a bull market. Moreover, most people get their sources of income under particular timeframes, so for those people (e.g., the majority) $\endgroup$ – linhares May 1 '15 at 12:50
  • $\begingroup$ Also, DCA allows one to gather more information as time evolves and market sentiment or new information changes. A lump sum investment takes away opportunity costs, so that may also be (unconsciously or consciously) considered in investor's decisions. $\endgroup$ – linhares May 1 '15 at 12:57
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It seems that despite the idea's intuitive appeal, the evidence is currently mixed with respect to whether loss aversion can explain dollar cost averaging strategies. Most research I can find seems to be financial and normative, pertaining to whether the strategy performs well more than behavioral and descriptive concerns for why people engage in the strategy.

An uncommonly direct study of this exact question reported, in no uncertain terms, that we cannot explain the tendency of investors dollar cost averaging in terms of loss aversion (Leggio and Lien, 1995).

Using prospect theory to create an alternative utility function that does not require investors to be strictly risk averse, we empirically test Statman’s conjecture for four investment strategies and for alternative stock investments. We find loss aversion still does not explain the existence of the dollar-cost averaging investment strategy.

Unfortunately, at least for our sense of certainty, this claim was challenged in a later study by Dicht and Drobetz (2011), which suggested the exact opposite: according to them, prospect theoretic can explain dollar cost averaging strategies with loss aversion within short time scales.

Overall, our results indicate that the popularity of dollar cost averaging can be explained within the framework of the Tversky and Kahneman’s cumulative prospect theory, at least for short time horizons.

There seems to be a complex, time-dependent relationship between dollar cost averaging and loss aversion. It's plausible that loss aversion drives the tendency to engage in dollar cost averaging over particular time scales or for particular classes of investors, but ultimately, we don't have the evidence to say.

References

  • Leggio, K. B., & Lien, D. (2001). Does loss aversion explain dollar-cost averaging?. Financial Services Review, 10(1), 117-127.
  • Dichtl, H., & Drobetz, W. (2011). Dollar-cost averaging and prospect theory investors: An explanation for a popular investment strategy. Journal of Behavioral Finance, 12(1), 41-52.
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  • $\begingroup$ Do those studies control for the i) predetermined schedule in which the majority of investors receive income; ii) the ability to re-evaluate as market sentiment or new information changes, and iii) the opportunity cost involved in a lump sum investment? That's why I find the hypothesis fascinating, but hard to test. $\endgroup$ – linhares May 1 '15 at 13:02
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    $\begingroup$ @linhares As far as I can tell: No, no and no. The research generally seems to be financially rather than behaviorally focused. $\endgroup$ – Christian Hummeluhr May 1 '15 at 13:30

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