Dollar Cost Averaging - The Role of Cognitive Error

Abstract

Dollar Cost Averaging (DCA) has long been shown to be an inefficient investment strategy in mean/variance terms, yet it remains very popular. Recent research has attempted to explain this popularity by assuming more complex investor preferences. However, this paper demonstrates that DCA is a sub-optimal strategy regardless of the form taken by investor preferences over terminal wealth. Instead it offers a simpler explanation: that DCA’s continued popularity is due to a specific and demonstrable cognitive error in the key argument that is normally put forward in favor of the strategy. This explanation brings very different welfare implications.

Keywords: Dollar cost averaging, investment, behavioral finance

JEL Classification: G10, G11