Take a look at this 5 min video about Dollar Cost Averaging by Professor Kenneth French.
Dollar (UK investors should read Pound) Cost Averaging, in this case refers to lump sums available for investment which, instead of immediately being fully invested in the markets, are allocated over a series of months. The objective is to avoid being caught out by sudden market falls shortly after making the investment. In the UK we call this ‘Phased Investment’.
Interestingly, Prof French reinforces the academically accepted view that Dollar Cost Averaging does not optimise returns, given the level of risk that an investor wishes to take. When considered purely from a finance perspective, if the right thing to do, in order to deliver a set of goals, is to invest in an equity portfolio, then it should be implemented in full, immediately. Market timing has been shown to contribute very little to returns and as a consequence there is no good reason to delay.
But, is this always right? Well ,Prof French observed that, from a behavioural finance point of view, it may be a good thing. People apparently feel worse about the negative outcomes from acts of comission (things they did) than they do about acts of ommission (things they didn’t do). Hence an investor feels a lot worse about the fact that his portfolio plummeted shortly after investing the money that he does about the returns which he failed to make because he didn’t invest the money.
On balance, Prof French concludes that, even with his finance professor’s hat on, the damage to prospective returns caused by Dollar Cost Averaging is very little, so it makes little difference whether investors use it or not. However, he observed that it may give them an experience that they feel better about.
Ultimately as investment professionals and, especially as financial planners, we do need to step outside of the theoretical world of optimised portfolios and look at things more closely from our client’s point of view. If doing things that are theoretically sub-optimal but not actually damaging makes our clients feel better about what they are doing then there is no good reason not to facilitate this. After all we are not on some kind of Evangelical mission to convert the pagan unwashed. Oh, and it is their money…. not ours.