As investors, we often face the dilemma of wanting high stock prices when we sell, 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 the markets and become tangled in the slippery slope of market timing, which is not advisable to a long-term investment strategy.
In this article, we'll 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).
Understanding Dollar Cost Averaging
DCA is a practice wherein an investor allocates a set amount of money 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 prices fall. The potential for this price drop is called a timing risk. That lump sum can be tossed into the market in a smaller amount with DCA, 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. In a DCA plan, you can avoid that timing risk and enjoy the low-cost benefits of this strategy by spreading out your investment cost.
One strategy that has started to gain favor is value averaging, which aims to invest more when the share price falls and less when the share price rises. Value averaging is conducted by calculating predetermined amounts for the total value of the investment in future periods, then by 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 is worth $625 (50 shares times $12.50), 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 below, 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:
The chart above indicates that a 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 dollar cost averaging for the same time period (and at a lower level of risk).
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 (sell high, buy low). Overall, value averaging is a simple, mechanical type of market timing that helps to minimize some timing risk.
Choosing Between DCA and VA Strategies
In using DCA, investors always make the same periodic investment. The only reason they buy more shares when prices are lower is that the shares cost less. In contrast, with VA investors buy more shares because prices are lower, and the strategy ensures that the bulk of investments are spent on acquiring shares at lower prices. VA requires investing more money when share prices are lower and restricts investments when prices are high, which means it generally produces significantly higher investment returns over the long term.
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 impact your portfolio as much as if you had invested all 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. When using a DCA strategy, 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.
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 result in missing a general upswing in the markets as inflation chips away at the real value of the cash.
For VA, one potential problem with the investment strategy is that in a down market, an investor might actually run out of money making the larger required investments before things turn around. This problem can be amplified after the portfolio has grown larger, when drawdown in the investment account could require substantially larger investments to stick with the VA strategy.
The Bottom Line
The DCA approach offers the advantage of being very simple to implement and follow, which is difficult to beat. DCA is also appealing to investors who aren't comfortable with the higher investment contributions sometimes required for the VA strategy. For investors seeking maximum returns, the VA strategy is preferable.
The justification of using DCA versus VA is dependent on your investment strategy. If the passive investing aspect of DCA is attractive, then find a portfolio you feel comfortable with and put in the same amount of money 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. In contrast, 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 of these strategies, we are assuming a buy-and-hold methodology – 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 may not be the best investment strategy. However, if you take a conservative investment approach, it may just provide the edge that you need to meet your goals.