Investors seek high stock prices when they sell, but not when they buy. As investors wait for a decline, they get lured away from the markets and become tangled in the slippery slope of market timing, which is not advisable for a long-term investment strategy.
Two investing practices that seek to counter the natural inclination toward market timing include dollar cost averaging (DCA) and value averaging (VA).
Key Takeaways
- Dollar-cost averaging requires an investor to allocate a set amount of money at regular intervals, usually shorter than a year.
- Dollar-cost averaging is generally used for more volatile investments such as stocks or mutual funds.
- Value averaging aims to invest more when the share price falls and less when the share price rises.
Dollar-Cost Averaging
When choosing dollar cost averaging (DCA), an investor allocates a set amount of money at regular intervals, usually monthly or quarterly. DCA is generally used for more volatile investments such as stocks or mutual funds, rather than bonds or CDs.
DCA is a good strategy for investors with lower risk tolerance. Investors who put a lump sum of money into the market at once, 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. With DCA, that lump sum can be invested into the market in a smaller amount, lowering the risk and effects of a single market move by spreading the investment out over time.
For example, an individual invests $1,000 each month for four months. If the prices at each month's end were $45, $35, $35, and $40, the average cost would be $38.75. If they had invested the whole amount at the start, the price would have been $45 per share.
Value Averaging
Value averaging (VA) 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, and then by investing to match these amounts at each future period.
Suppose an investor determines their investment will rise by $500 each quarter as they make additional investments. They invest $500 at $10 per share first for 50 shares. They determine the investment will rise to $1,000 in the next period. If the current price is $12.50 per share, the original position is worth $625 (50 shares times $12.50), which only requires an investment of $375 to reach $1,000. This is done until the end value of the portfolio is reached. The individual invested less as the price rose. The opposite would be true if the price had fallen.
Example
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The chart indicates that a majority of shares are purchased at low prices. When prices drop and individuals invest more, they acquire more shares. Most of the shares have been bought at low prices, thus maximizing returns when it comes time to sell. If the investment is sound, VA will increase returns beyond dollar-cost averaging for the same period andat a lower level of risk.
If there is a sudden gain in the market value of a stock or fund, value averaging could even require investors to sell some shares. Overall, value averaging is a simple, mechanical type of market timing that helps to minimize some timing risks.
What Is a Risk When Using DCA?
All risk-reduction strategies have their tradeoffs, and DCA is no exception. Investors risk missing out on higher returns if the investment rises after the first period. Also, when spreading a lump sum, the money waiting to be invested doesn't garner a return by just sitting there. Still, a sudden price drop won't impact a portfolio as much as if they had invested all at once.
What Is a Downside of Choosing VA?
A potential problem with the investment strategy of VA is that in a down market, an investor might run out of money, making larger required investments before things turn around. This problem can be amplified after the portfolio has grown when a drawdown in the investment account could require substantially larger investments to stick with the VA strategy.
How Do Dividends Affect DCA?
Besides purchasing shares at set intervals using DCA, stocks that pay dividends allow investors to reinvest those dividends in the underlying shares using the Dividend Reinvestment Plan (DRIP) strategy. DRIP can be thought of, essentially, like dollar-cost averaging on autopilot.
The Bottom Line
The DCA approach is simple to implement and follow. For investors seeking maximum returns, the VA strategy is preferable. Choosing DCA versus VA depends on an individual's investment strategy. If the passive investing aspect of DCA is attractive, investors can put in the same amount of money monthly or quarterly. If investors prefer active investing, value averaging may be a better choice. In both strategies, investors choose a buy-and-hold methodology, finding a stock or fund and selling it only if it becomes overpriced.
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