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What advice should a financial planner give to a client who wants to invest a large sum of money in the bond market? The client understands and is willing to accept the risks of long-term bond investing but is uneasy about possibly investing the entire endowment at a market peak. Should the money be invested all at once or gradually invested over time using a dollar-cost averaging (DCA) strategy?
The conventional wisdom seems to be that a DCA approach is preferred. For example, in February 1995, Vanguard's head of fixed income investing recommended DCA for those investors who rushed out of the bond market early in 1994, when rates started to rise and wanted to re-enter the market to take advantage of higher yields [2]. Presumably, DCA would minimize the risk of investing the entire amount just before a dramatic move upward in interest rates. Although recent studies have cast considerable doubt on the effectiveness of DCA as a technique for investing in equities [4, 6, 7], little attention has been paid to a DCA strategy applied to long-term bonds. This study fills a gap in the literature by examining the investment performance of a DCA strategy applied to both corporate and Treasury bonds over the period 1926 to 1995.
Data and Methodology
Data for the study comes from Ibbotson Associates 1996 Yearbook. The original data consists of monthly rates of return for both income and capital gains for Treasury bonds, corporate bonds and 90-day Treasury bills. We combine the income and capital gains returns to get an overall return for each type of security.
The study compares two investment strategies:
1. A lump-sum (LS) strategy in which the entire fund is invested immediately in either Treasury or corporate bonds
2. A DCA strategy whereby the entire amount is initially invested in Treasury bills (T-bills) and then gradually shifted to Treasury or corporate bonds in equal monthly installments.
As an example of the computational procedure to be followed, consider a $120,000 endowment to be invested in corporate bonds during the period January 1, 1993, to December 31, 1993. Monthly rates of return for T-bills and corporate bonds for this period are shown in Table 1.
Under the LS strategy, the entire $120,000 would be invested...