The risk and return of investment averaging
An option-theoretic approach
DOI:
https://doi.org/10.61190/fsr.v13i4.4801Keywords:
Shortfall, Automatic investment plan, Asian options pricing, Dollar cost averagingAbstract
Automatic stock investment plans are touted to offer dollar cost averaging (DCA) advantages. Rather than focusing on potential lower costs and thus enhanced returns, we analyze the impact of the averaging on the risk of the investment. We use an option theory-based simulation model to computing the standard deviation of the realized return the probability of shortfall and the conditional expected shortfall for a periodic DCA plan. The plan's terminal value depends on the total number of shares acquired over time. The number of shares is a stochastic variable that depends on the volatility of the underlying stock. We show that the risk reduction because of averaging is significant not only in terms of standard deviation, but also in terms of the expected shortfall of funds when the investment turns a loss. We show that the DCA benefits are greater, the longer the averaging, and the riskier the underlying investment.
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Copyright (c) 2004 Academy of Financial Services
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