We’ve covered dollar-cost averaging (DCA) previously, but for you strange people who haven’t read every word of this blog, it’s essentially buying a fixed dollar amount of stock at set intervals. For example, investing $500/month for 10 months. True DCA really refers to the idea of doing this for a lump sum, i.e. gradually investing the $10k you’ve got sitting in your checking account instead of doing it all at once. The idea behind this is to avoid accidentally investing at a relative market peak. Of course, if you’re playing good Defense you’re already getting the “benefits” of DCA simple because you’re regularly investing anyway. Because typically the market goes up and also because it is impossible to predict relative highs or lows (and, it’s possible that the market will never be as low right now), I recommend against DCA. Read the linked article above if you want me details.
What is Value Averaging?
Today we’re talking about Value Averaging (VA), which is essentially DCA on steroids. I was introduced the VA in The Intelligent Asset Allocator, a book I highly recommend. Here’s how it works. Instead of setting a fixed amount to invest at a regular interval, you set a target portfolio value that you want to reach. Let’s go through an example. Preston has $50k in cash. He decides he wants to have this much money for the following 10 months:
In other words, if the market is flat he’ll be putting in $5k each month. But let’s say you put in $5k, and one month later the market has dropped by 20% and he now only has $4k. Then he would contribute $6k instead of $5k in order to bring his total up to $10k. But if the market went up by 20% and he had $6k, then he’d only contribute $4k.
What’s the rationale behind this? Consider the first case, where Preston contributes $6k after one month. At that time, the market is “cheaper” than when you started investing. With DCA, the fixed contribution would buy you additional shares for the same dollar amount (since each share costs less money). This is good, since you’re “buying low”. But with VA, you increase your dollar amount when shares become less expensive, magnifying this effect. Pretty cool, right?
Just kidding, it is kind of cool. So should you do it? Probably not. First of all, you can easily see how Preston might just not have enough money to execute his plan if the market is down for most or all of the 10 months. Of course in that case he’d still buy a bunch of cheap shares, so it’s not all bad. On the other hand, it might take him much longer than 10 months to complete his investment if the market rises rapidly, as it sometimes does. In that case, both DCA and VA would be vastly inferior to just investing the lump sum.
Also, I find Preston’s situation (and others like it) to be very unrealistic. In life, you’re typically either regularly adding to your stash and withdrawing from it in retirement. Unless you have income that exactly matches your necessary spending, you’re going to be investing regularly anyway. I saw just invest the lump sum and still retain the benefits of DCA/VA anyway with your regular paycheck.
Who should Value Averaging?
If you really can’t stand the risk of seeing your lump sump investment temporarily shrink due to a market dip, and you really want to do something like DCA, then go ahead and value average. That should give you a little more bang for your buck. But be warned, VA takes more mental fortitude than DCA, since you’ll be going against the market (buying when everybody else is scared and selling) in a more drastic way. And if you can stomach that then you should really consider just investing the lump sum all at once anyway. Lastly, if you’re just really into the buying low idea and want to take advantage of that, I’d consider just a regular old Asset Allocation strategy. Of course, simply investing all your money, whenever you have extra money, in a total US stock market index fund like VTI is the simplest and potentially the most effective avenue anyway.
- Value averaging is like dollar-cost averaging, but with increasing investment at “cheaper” market prices.
- In a choice between the two, I’d recommend value averaging since it takes additional advantage of cheaper stock prices.
- Value averaging requires more mental fortitude than dollar-cost averaging, and some of the benefits of both approaches can already by gained by simply allocating your assets.
- If you don’t care about any of this, just keep on putting your money in VTI and enjoy being filthy rich in a decade or two.