4 ms·

The sharpe ratio is a common metric used to balance risk and reward. Based on the figures in this article, I'm almost positive that "lump sum" would outperform

The sharpe ratio is a common metric used to balance risk and reward. Based on the figures in this article, I'm almost positive that "lump sum" would outperform DCA's sharpe as well. A good way to respond to your example would also be to bring in a discussion of the St. Petersburg paradox and expected utility theory.

seanhunter 3y ago
I don't think Sharpe is the right metric here and it has the same flaw as the article. Neither the article nor the sharpe ratio would take into account the fact that in his test much of the capital would remain uninvested for the begining of the dollar cost averaging strategy so it would seem to underperform literally because far less capital would be put to work for the beginning of the test period. The use case for lump sum and dollar cost averaging (or "Systematic investment" that he mentions in the article, which sounds very much like what I have always called DCA but whatever) are different. Most people don't have a chunk of cash to invest, most people have some small amount of excess cash to invest each month or whatever. So in that world are you better off investing each month, or saving up until you have a lump sum? Almost certainly investing[1] each month. For that reason, most people in the investment world would use some variant on internal rate of return here, which you could do a risk-adjusted variant of if you wanted to. I expect if you used either of those metrics you would find that DCA pays a small amount of excess return in cases when you would luck out and invest big after a decline in the lump sum case. In return for this, DCA has far lower variance, and far less likelihood of "effective ruin"[2]. [1] Technically if your savings amount each month is very small the transaction costs will eat up your capital if you trade too often so you should save until you have chunkier amounts in that case to mitigate this. [2] Strictly if you're just investing long in cash equities (not derivs) risk of ruin is practically zero, but for a real person you can be very significantly harmed if say you bought equities at some high water mark, there is a big sell-off, the market basically goes sideways (declines in real terms after inflation) for a long period of time and you have to retire (so you have no earning power) and have to sell gradually at a loss to sustain your standard of living in retirement. This is effectively the position a lot of Japanese investors found themselves in after the big slump there.
- bitshiftfaced 3y ago
  The underlying idea behind DCA is that by investing a fixed amount every month, you'll naturally buy less shares when the market is overheating and more shares when it's undervalued. Contrast this with trying to time the market so that you're buying up shares during a down market. The author substituted in "buy immediately" for "time the market." I'd say that the strategy you're referring to is the same as "buy immediately (whenever you can afford it)," but interpreted in a DCA light. You're right that it matters if we're talking about whether or not you have an existing savings you want to invest. But I don't see that distinction to matter here, since many people believe DCA is powerful because it rejects the idea of market timing and reduces risk, not because they're trying to put their money to work as fast as possible.
  - seanhunter 3y ago
    Yeah. Pretty sure the "magic" of DCA is just the magic of compounding. To be fair though that is one of the most powerful things in finance.

seanhunter 3y ago

I don't think Sharpe is the right metric here and it has the same flaw as the article. Neither the article nor the sharpe ratio would take into account the fact that in his test much of the capital would remain uninvested for the begining of the dollar cost averaging strategy so it would seem to underperform literally because far less capital would be put to work for the beginning of the test period. The use case for lump sum and dollar cost averaging (or "Systematic investment" that he mentions in the article, which sounds very much like what I have always called DCA but whatever) are different. Most people don't have a chunk of cash to invest, most people have some small amount of excess cash to invest each month or whatever. So in that world are you better off investing each month, or saving up until you have a lump sum? Almost certainly investing[1] each month. For that reason, most people in the investment world would use some variant on internal rate of return here, which you could do a risk-adjusted variant of if you wanted to. I expect if you used either of those metrics you would find that DCA pays a small amount of excess return in cases when you would luck out and invest big after a decline in the lump sum case. In return for this, DCA has far lower variance, and far less likelihood of "effective ruin"[2]. [1] Technically if your savings amount each month is very small the transaction costs will eat up your capital if you trade too often so you should save until you have chunkier amounts in that case to mitigate this. [2] Strictly if you're just investing long in cash equities (not derivs) risk of ruin is practically zero, but for a real person you can be very significantly harmed if say you bought equities at some high water mark, there is a big sell-off, the market basically goes sideways (declines in real terms after inflation) for a long period of time and you have to retire (so you have no earning power) and have to sell gradually at a loss to sustain your standard of living in retirement. This is effectively the position a lot of Japanese investors found themselves in after the big slump there.

bitshiftfaced 3y ago
The underlying idea behind DCA is that by investing a fixed amount every month, you'll naturally buy less shares when the market is overheating and more shares when it's undervalued. Contrast this with trying to time the market so that you're buying up shares during a down market. The author substituted in "buy immediately" for "time the market." I'd say that the strategy you're referring to is the same as "buy immediately (whenever you can afford it)," but interpreted in a DCA light. You're right that it matters if we're talking about whether or not you have an existing savings you want to invest. But I don't see that distinction to matter here, since many people believe DCA is powerful because it rejects the idea of market timing and reduces risk, not because they're trying to put their money to work as fast as possible.
- seanhunter 3y ago
  Yeah. Pretty sure the "magic" of DCA is just the magic of compounding. To be fair though that is one of the most powerful things in finance.