Taking averages with a pinch of salt

The stock market can be a volatile beast, as the last few months have shown. While most international markets are again trading near all-time highs, the very thought of investing a lump sum near a market top is enough to put most people off their food.

What if the market crashes? What if they lose 30 per cent or 50 per cent of their investment? What if they have to wait 20 years to get their money back?

The popular technique of dollar-cost averaging (DCA) is designed to ease such nerves. With DCA, the investor doesn't commit all of his or her money up front. Instead of making a lump sum investment of, say, €12,000, the DCA investor would invest €1,000 a month over a year.

The rationale is that more shares are bought when prices are low, fewer shares are purchased when prices are high.

According to US personal finance guru Suze Orman: "Even if you are investing for the long run [ 10 years or more] and the market goes down, in the end you will be a winner," while www.motleyfool.com, the celebrated investment website, says DCA is "the perfect way to take advantage of stock fluctuations".

It says: "In many cases, an investor who dollar-cost averages into a stock outperforms an investor who simply buys a bulk amount and holds for years".

There's just one problem - it's rubbish. Compared to a simple lump-sum investment, dollar-cost averaging is a loser's game.

Since 1950, dollar-cost averaging with the S&P 500 has failed to beat investing the lump sum at the start of the year in two years out of three. Indeed, the longer one's holding period, the poorer the returns.

Academics are almost uniformly scornful on the subject.

In 2006, in a research paper, Mathematical Illusion: Why Dollar-Cost Averaging Does Not Work, finance professor John Greenhut dismissed it as having "psychological appeal" and little else.

Since the 1970s, academic paper after paper has confirmed that DCA results in poorer returns than an initial lump sum investment. At the end of the day, markets tend to rise over time. The greater the initial sum invested, the greater the eventual returns.

When an investor opts to drip-feed his money into the market, he is forsaking the likely returns on offer. Still, many would gladly give up a couple of percent in annual returns for the supposed reduction in risk offered by DCA.

You get less performance, but also less exposure to those ups and downs.

Unfortunately, lofty claims that DCA is some kind of magic risk-reduction mechanism don't stand up to scrutiny.

Another academic paper, by two Connecticut researchers, concluded that "no such benefit accrues to a dollar-cost averaging strategy" and that "the additional cost and effort associated with dollar-cost averaging cannot be justified for any investor, regardless of degree of risk aversion".

All this will doubtless surprise most investors. After all, examples of DCA are invariably accompanied by a table showing the investor finishing nicely ahead while the poor lump sum investor is playing catch-up after naively investing at the top of the market.

A DCA approach will indeed outperform in a downward market but, as already pointed out, markets spend most of their time heading north.

Why then do so many investment professionals push this strategy? Critics sniff that it is little more than a clever marketing gimmick - after all, it's a lot easier to get a would-be investor to commit to payments of €1,000 a month over five years than it is for him to extract an initial lump sum of €50,000-plus.