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Executive Summary
* The cost benefit of dollar-cost averaging (DCA)-a constant dollar amount buys more at lower prices and buys less at higher prices-is dubious, since one cannot predict the path of prices.
* The risk-reduction benefit of DCA is real: averaging over time is akin to buying less-than-perfectly correlated assets. This produces a lower volatility of the terminal value of the investment-that is, a more certain outcome.
* Averaging results in a much lower expected shortfall when losses occur. Retirement investors pursuing DCA over a long time will face much less "disappointment" if the price path of their investments leads to a loss.
* The longer the averaging period relative to the total investment horizon, the greater the risk reduction.
* The volatility reduction can be as high as 40 percent, and the shortfall reduction as high as 30 percent, if averaging spans the entire investment horizon.
* Risk reduction, and not cost savings, should be used as a primary argument for recommending DCA-like automatic investment plans to all long-term investors.
To date, research on dollar-cost averaging (DCA) has focused on the strategy's cost advantages: a constant amount buys more when the price drops and less when the price increases. If the price fluctuates, the DCA scheme is said to lead to a lower cost per share and a greater total return. Several studies have debunked this wisdom by comparing an upfront lump-sum (LS) strategy (for example, $1,200 invested once) with a present-value-corrected DCA ($100 invested immediately, the rest parked in T-bills and in equal installments shifted into stocks over one year). Using historical data from the S&P 500, Williams and Bacon (1993) succinctly show that because the average return on stocks is higher than on T-bills, two-thirds of the time a 12month LS strategy beats a 12-month DCA strategy in total terminal wealth, as it simply amounts to investing at the beginning of the year rather than spreading purchases throughout the year and forgoing the positive excess return. Focusing on the seasonally of stock returns, Atra and Mann (2001) point out that LS beats DCA when started in November, as LS takes advantage of abnormally high returns in December and January, and DCA misses those; the opposite is true for strategies started...