How smart is periodic investing?

Periodic investingFor investors it is all about the end result. If that also goes for you, periodic investing is not for you. Under normal circumstances, it is assumed that return on equity is higher than return on savings. A strategy which periodically invests a portion of its assets in equities and where the remainder is on the savings account, does not win from a strategy which invests everything in equities.

If everyone understands that investing periodically normally does not yield more at the end of the day, why is it so popular? The answer is closely related to the demand side. For investors who are only interested in the highest yield at maturity it is true that they are better off investing everything in shares. But investors are not rational beings which provides arguments that justify the choice of periodic investing.

Dollar cost averaging

An example of the rationale for periodic investing, or dollar cost averaging, as it is often referred to in the literature, comes from Meir Statman. He proposes four arguments. The first is the prospect theory which states that the way in which an investment choice is presented (framing) affects the final decision.

Suppose you have the choice between a sure gain of 500 euro or 50% chance of 1,000 Euros profit and 50% chance of nothing. Most people choose one option. You better have it in your pocket. But when we get to choose between option three, a certain loss of €500, and option four, 50% chance of a loss of 1,000 Euros and 50% chance of nothing, then we tend to choose option four. This is not in accordance with the choice of a rational person.

The expected yield is, apart from the minus sign, the same. But precisely that negative sign makes the difference. Losses hurt more than profits. The way in which the choice is presented, in terms of profit or loss, affects our decision.

Periodic investing

We can apply the same concept to periodic investing. Suppose you buy every month for EUR 1,000 shares X. In period one you buy 10 shares X for 100 Euros. The share price drops in that period to 20 Euros. So, in period two you buy 50 shares. You now have 60 shares with an average acquisition price of 33.33 Euros, while the average price over the period was 50 Euros.

You bought “cheap”, and decide to continue investing periodically. You conveniently forget that you are at a loss of 800 Euros. framing also plays an important role here. The way in which periodic investing is presented affects our willingness to actually invest that way. A second argument is regret. Suppose you invest everything at once. Within the first year, the stock market fall 50%. Then you regret your decision, and like losses, regret is a heavy burden for an investor. To have no regrets, you can invest in accordance with a certain rule. Then at least you can tell yourself “it was not my fault”.

Periodic investing is such a rule. The relationship between the amount of responsibility an investor has and the amount of regret has been demonstrated in the literature. With periodic investing you have little responsibility and therefore little regret. Finally, Statman cites two other factors: cognitive mistakes (quit investing after a significant setback) and self-discipline (to not be distracted from the goal, which is investing). These factors are also used as an argument for periodic investing. The periodic investment continues.

Take a broader look

The conclusion? If you look beyond the expected yield at maturity there are a number of arguments that underpin the choice for periodic investing. As Statman began his study: “Dollar cost averaging may not be rational behaviour, but it is perfectly normal behaviour.”