As investors, we face a bit of a dilemma: we want high stock prices when we sell a stock, but not when we buy. There are times when this dilemma causes investors to wait for a dip in prices, thereby potentially missing out on a continual rise. This is how investors get lured away from investing and become tangled in the slippery science of market timing - a science that few people can hope to master.

In this article, we will look at two investing practices that seek to counter our natural inclination toward market timing by canceling out some of the risk involved: dollar cost averaging (DCA) and value averaging (VA).

Dollar Cost Averaging
DCA is a practice where an investor puts a set amount of money into investments at regular intervals, usually shorter than a year (monthly or quarterly). DCA is generally used for more volatile investments such as stocks or mutual funds, rather than for bonds or CDs, for example. In a broader sense, DCA can include automatic deductions from your paycheck that go into a retirement plan. For the purposes of this article, however, we will focus on the first type of DCA.

DCA is a good strategy for investors with a lower risk tolerance. If you have a lump sum of money to invest and you put it into the market all at once, then you run the risk of buying at a peak, which can be unsettling if the prices fall after the investment. The potential for this price drop is called a timing risk. With DCA, that lump sum can be tossed into the market in a smaller amount, lowering the risk and effects of any single market move by spreading the investment out over time.

For example, suppose that as part of a DCA plan you invest $1,000 each month for four months. If the prices at each month's end were $45, $35, $35, $40, your average cost would be $38.75. If you had invested the whole amount at the start of the investment, your cost would have been $45 per share. By using a DCA plan, you can avoid timing risk and enjoy the low-cost benefits of this strategy by spreading out your investment cost.

DCA Pitfalls
All risk-reduction strategies have their tradeoffs, and DCA is no exception. First of all, you run the chance of missing out on higher returns if the investment continues to rise after the first investment period. Also, if you are spreading a lump sum, the money waiting to be invested doesn't garner much of a return by just sitting there. Still, a sudden drop in prices won't damage you as much as if you had put it all in at once.

Some investors who engage in DCA will stop after a sharp drop, cutting their losses; however, these investors are actually missing out on the main benefit of DCA - the purchase of larger portions of stock (more shares) in a declining market, thereby increasing their gains when the market rises again. When using a DCA strategy, therefore, it is important to determine whether the reason behind the drop has materially impacted the reason for the investment. If not, then you should stick to your guns and pick up the shares at an even better valuation than before.

Another issue with DCA is determining the period over which this strategy should be used. If you are dispersing a large lump sum, you may want to spread it over one or two years, but any longer than that may mean missing the general upswing in the markets as inflation chips away at the real value of the cash.

DCA may not, however, be the best choice for a long-term investment strategy. It may not even be the best choice for dispersing a lump sum.

Enter Value Averaging
One strategy that has started to gain favor is the value averaging technique, which aims to invest more when the share price falls and less when the share price rises. It is done by calculating predetermined amounts for the total value of the investment in future periods and then making an investment to match these amounts at each future period.

For example, suppose you determine that the value of your investment will rise by $500 each quarter as you make additional investments. In the first investment period, you would invest $500, say at $10 per share. In the next period, you determine that the value of your investment will rise to $1,000. If the current price is $12.50 per share, your original position comes to be worth $625 (50 shares times $15), which only requires you to invest $375 to put the value of your investment at $1,000. This is done until the end value of the portfolio is reached. As you can see in this example, you have invested less as the price has risen, and the opposite would be true if the price had fallen.

Therefore, instead of investing a set amount each period, a VA strategy makes investments based on the total size of the portfolio at each point. Below is an expanded example comparing the two strategies:

S-DCAVA.gif

As you can see, the majority of shares are purchased at low prices. When prices drop and you put more money in, you end up with more shares (this happens with DCA as well, but to a lesser extent). Most of the shares have been bought at very low prices, thus maximizing your returns when it comes time to sell. If the investment is sound, VA will increase your returns beyond simply dollar cost averaging for the same time period. And it does so at a lower level of risk.

Additionally, in certain circumstances, such as a sudden gain in the market value of your stock or fund, value averaging could even require you to sell some shares without buying any (sell high, buy low). Value averaging is a simple, mechanical type of market timing that helps to minimize timing risk.

The Bottom Line
Choosing between the two depends on your reasons. If it is the passive investing aspect of DCA that attracts you, then stick to it. Find a portfolio you feel comfortable with and put the same amount of money into it on a monthly or quarterly basis. If you are dispersing a lump sum, you may want to put your inactive cash into a money market account or some other interest-bearing investment. If you are feeling ambitious enough to engage in a little active investing every quarter or so, then value averaging may be a much better choice.

In both these cases, we are assuming a buy-and-hold strategy - you find a stock or fund that you feel comfortable with and purchase as much of it as you can over the years, selling it only if it becomes overpriced.

Legendary value investor Warren Buffet has suggested that the best holding period is forever. If you are looking to buy low and sell high in the short term, by day trading and the like, then DCA and value averaging are of little use. If you invest conservatively, however, it may just provide the edge that you need to meet your goals.

Related Articles
  1. Mutual Funds & ETFs

    Top 3 Switzerland ETFs

    Explore detailed analysis and information of the top three Swiss exchange-traded funds that offer exposure to the Swiss equities market.
  2. Mutual Funds & ETFs

    Top 5 Chinese Mutual Funds

    Learn about some of the most popular and best performing mutual funds that offer investors exposure to the important emerging market economy of China.
  3. Investing Basics

    Explaining Unrealized Gain

    An unrealized gain occurs when the current price of a security exceeds the price an investor paid for the security.
  4. Investing Basics

    Explaining Risk-Adjusted Return

    Risk-adjusted return is a measurement of risk for an investment or portfolio.
  5. Investing Basics

    Calculating the Margin of Safety

    Buying below the margin of safety minimizes the risk to the investor.
  6. Fundamental Analysis

    Is India the Next Emerging Markets Superstar?

    With a shift towards manufacturing and services, India could be the next emerging market superstar. Here, we provide a detailed breakdown of its GDP.
  7. Mutual Funds & ETFs

    ETF Analysis: iShares Agency Bond

    Find out about the iShares Agency Bond exchange-traded fund, and explore detailed analysis of the ETF that tracks U.S. government agency securities.
  8. Investing Basics

    If You Had Invested Right After Amazon's IPO

    Find out how much you would have made if you had invested $1,000 during Amazon's IPO, including how the power of the stock split affects investment growth.
  9. Mutual Funds & ETFs

    ETF Analysis: PowerShares S&P 500 Low Volatility

    Find out about the PowerShares S&P 500 Low Volatility ETF, and learn detailed information about this fund that provides exposure to low-volatility stocks.
  10. Mutual Funds & ETFs

    ETF Analysis: Vanguard Intermediate-Term Bond

    Find out about the Vanguard Intermediate-Term Bond ETF, and delve into detailed analysis of this fund that invests in investment-grade intermediate-term bonds.
RELATED TERMS
  1. Supply

    A fundamental economic concept that describes the total amount ...
  2. Principal-Agent Problem

    The principal-agent problem develops when a principal creates ...
  3. Exchange-Traded Fund (ETF)

    A security that tracks an index, a commodity or a basket of assets ...
  4. Discount Bond

    A bond that is issued for less than its par (or face) value, ...
  5. Passive Income

    Earnings an individual derives from a rental property, limited ...
  6. Compound Annual Growth Rate - CAGR

    The Compound Annual Growth Rate (CAGR) is the mean annual growth ...
RELATED FAQS
  1. What does a high turnover ratio signify for an investment fund?

    If an investment fund has a high turnover ratio, it indicates it replaces most or all of its holdings over a one-year period. ... Read Full Answer >>
  2. What is the utility function and how is it calculated?

    In economics, utility function is an important concept that measures preferences over a set of goods and services. Utility ... Read Full Answer >>
  3. What is the difference between passive and active asset management?

    Asset management utilizes two main investment strategies that can be used to generate returns: active asset management and ... Read Full Answer >>
  4. What percentage of a diversified portfolio should large cap stocks comprise?

    The percentage of a diversified investment portfolio that should consist of large-cap stocks depends on an individual investor's ... Read Full Answer >>
  5. Why should an investor include an allocation to the telecommunications sector in ...

    An investor should include an allocation to the telecommunications sector in his portfolio, because telecom offers an investor ... Read Full Answer >>
  6. What are some mutual funds that do not have 12b-1 fees?

    Some of the most popular and best-performing mutual funds that do not include any 12b-1 fees in the expenses charged to fund ... Read Full Answer >>

You May Also Like

Trading Center
×

You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!