When investing in stocks, bonds, mutual funds or ETFs, the term “dollar cost averaging” is usually mentioned as the no-frills approach to investing. This post will compare dollar cost averaging to dollar value averaging and discuss their pros and cons.
DCA is a relatively simple and practical approach to investing, where we invest a small amount of money each week (if mutual funds, since they carry no trading commissions), month or quarter (if stocks, bonds or ETFs). This ensures that the buy price is averaged out since the periodic amount is set, no matter Mr. Market’s whims.
Say, if an investor were to buy $500 worth of mutual funds (I’m using them for convenience since trading commissions are avoided) each month, then they would buy more units when the price is low (@ $10 per unit, one would get 50 units for that month) and lesser units when the price is higher (@ $25 per unit, one would get 20 units for that month). So, after two months, the investor would own 70 units with an adjusted cost base of $14.28 per unit. This method, essentially, takes emotion (panic, greed and the like) out of the equation as long as the investor sticks to his investment policy, which would be to invest $500 at periodic intervals (every month in this case) through thick and thin.
Dollar Value Averaging (DVA)
DCA is a good method for many investors who do not have the time and/or interest and/or skill to control their investments. For those that do, DVA may be worth looking at.
DVA involves setting a target rate of return for the overall portfolio. In other words, DVA requires the investor to specify an expected (preferably real) rate of return, be it 3%, 4%, or 5%, for the whole portfolio. As an example, assume that an investor has an expected real rate of return of 5%. Say, he contributes $2500 for the first quarter and buys shares in ABC, DEF, and ZYX Corporations (I’m leaving out the trading commissions for ease but they should be included when calculating for a real portfolio).
After the first quarter, the value of the total stock portfolio goes up to $2700. But, based on the investor’s target growth rate, the portfolio should have been $2625 (i.e., 2500*1.05). So, the investor would only contribute $2425 [calculated as (2500*1.05+2500)-2700] for the second quarter to bring the portfolio value to its target (he could split the $2425 among the 3 stocks based on his planned sector-wise allocation or buy new stocks). Refer to a simple but detailed example here.
Instead, if the investor was dealing with a big windfall of $100,000 that he did not plan to add to, then based on the above example’s rate, he should have $105,000 (100,000*1.05) after one year. But, if his portfolio returned 10% after a year through a market upswing, then he would withdraw $5000 [(100,000*1.1)-(105,000)] to bring the portfolio to its 5% target return (which stock should be sold if there are multiple winners requires due diligence). This process will continue every year, i.e., the total portfolio value should be $110,250 (105,000*1.05) after the second year; the investor would have to add or withdraw cash based on the actual portfolio value. This method ensures that the investor will buy (invest) less when the share price is higher (since the portfolio value will be higher than expected, he needs to contribute less for the next period) and more when the share price is lower.
Is one better than the other?
Pros and Cons of DCA
- DCA makes the investor buy shares or units for the same set amount of contribution at periodic intervals. This cycle would repeat on an automatic basis irrespective of market movements, thereby eliminating investor interference.
- But, this lack of investor input also means lack of control, i.e., the contribution remains the same even in an overvalued market.
Pros and Cons of DVA
- DVA makes the holder invest lesser amounts when the prices rise and higher amounts when the prices drop, thereby providing better value (no pun intended).
- DVA does this by defining an expected rate of return, which should be realistic, and works to keep the portfolio on track. Thus, the value-averaging investor has a target in mind and stays aware of his progress or regress. The final return will not be higher than the expectation, since the investor may buy less or even sell at times of a market upswing.
- DVA requires active investor participation but may offer enhanced rewards. Evidently, such an active role means that the investor needs to spend more time than DCA.
- Nonetheless, the major drawback is that in a severe market downturn à la 2008, it would take significant contributions to get the portfolio on track – money that many investors may not have!
The bottom line is that DCA and DVA are two different methods to invest – each with their own limitations. The unifying factor is that both promote saving money, which is the fundamental building block for a successful future.
Do you use one of these methods for investing? Are there other points worth remembering about either? Has someone tried both?
About the Author: Clark works in Saskatchewan and has been working to build his (DIY) investment portfolio, structured for an early retirement. He loves reading (and using the lessons learned) about personal finance, technology and minimalism. You can read his other articles here.