Financial Accounting Blog

Wednesday, October 13, 2004

Does dollar-cost averaging work for bonds? I came across this 1997 paper that provides some evidence on the question. The idea with dollar-cost averaging is that you invest a set dollar amount into your investment each period. That way, when prices fall you'll buy more units (e.g. shares) of the investment and fewer units when the price rises.
Based on historical evidence, the major conclusion of our study is that an investor is better off, in terms of return and risk-adjusted performance, investing the lump sum immediately. Even investors who have a high degree of risk aversion would find that a simple buy-and-hold strategy allocating 50 percent to T-bills and 50 percent to bonds produces approximately the same return with lower risk than a 12-month DCA strategy.

How do we account for these results? The primary explanation seems to revolve around the positive risk premiums that existed in the great majority of time periods. From 1926 to 1995, T-bills produced an average return of approximately 3.7 percent, while corporates and Treasuries produced returns of approximately 5.9 percent and 5.4 percent, respectively. Thus, there was a relatively high opportunity cost associated with holding the uninvested portion of the fund in a risk-free asset.