Systems Approach to Investment Management: Does Constant Proportion Investment Beat Volatility Pumping?

Abstract

This article compares common investment systems used in investment management: value averaging, dollar cost averaging, and volatility pumping. To date no one has compared all three in a consistent framework. This study uses monte carlo simulation and widely available asset classes to study the behavior of these investment systems under different scenarios. After proposing a normative approach to comparing financial systems, the monte carlo study is extended by examining the performance of these investment systems under extreme scenarios, which are of interest to investors given the recent turmoil in financial markets. For large cap and small stock portfolios we see that constant proportion investing dominates dollar cost and value averaging. It is also shown that value averaging does not dominate dollar cost investing as claimed by prior research once tested with both continuously compounded return and adjusted or modified IRR where positive cashflows are not reinvested in a risk free asset and included in the final return. By simulating extreme scenarios value averaging dominates both dollar cost averaging and constant proportion investing due to the condition that positive cashflows above the value path are invested in a risk free asset. We also show that as expected in extreme scenarios all 3-investment systems perform better than the individual assets themselves.

Keywords: asset allocation, investment, system, risk/reward, simulation, volatility pumping, optimization, monte carlo simulation

JEL Classification: G11