When it comes to investing, there are a lot of different strategies that you can use to grow your money. One of the most popular choices is dollar-cost averaging, which involves investing a fixed sum of money into a stock or stocks at fixed intervals. Another option is value averaging, which is a more sophisticated strategy that takes into account the current market conditions when deciding how much to invest. So, what are the differences between dollar-cost averaging vs value averaging? And which one is right for you?
In this article, we will explore the advantages and disadvantages of dollar-cost averaging vs value averaging and help you choose which one of these strategies is the best for you.
What is dollar-cost averaging?
Dollar-cost averaging (DCA) is an investing strategy in which an investor buys a fixed dollar amount of a security or securities at fixed intervals. The idea behind this strategy is to reduce the effects of market volatility by buying more shares when prices are low and fewer shares when prices are high.
Dollar-cost averaging example
For example, let's say you want to invest $100 into XYZ stock every month. Over the course of 12 months, the price of XYZ stock fluctuates from $50 to $150 per share. If you had invested all $1200 at once, you could have caught the bottom at 24 shares at $50 per share. This will give you an average of $50 per share.
However, that is not always the case. Investing right at the bottom is difficult to do. If you were to believe that the stock was already at the bottom at $120, you would have invested all $1200 at once for 10 shares. This would have given you an average of $100 per share. Now, let's imagine that you used a DCA strategy instead.
At the end of 12 months, you would have purchased 12 shares for an average price of $100 per share. Even though the stock went down to $50 per share, you would have still averaged a purchase price of $100 per share.
Dollar-cost averaging can be a good strategy for investors who are risk-averse or who have a limited budget for investing. By buying securities over time, you reduce the chances of losing money if the market takes a sudden turn. Dollar-cost averaging also allows you to invest a fixed dollar amount instead of buying shares.
In this example, if you believed the bottom of the market was above $120 and bought then, you would have been better off with a Dollar-cost averaging strategy.
What is value averaging?
Value averaging (VA) is an investment strategy that involves investing a fixed sum of money into security or securities at regular intervals. However, unlike dollar-cost averaging, the amount invested each period is based on the current market value of the security.
Value averaging is the approach value investors use to dollar-cost averaging. It differs from DCA because value investors are not only concerned with the fixed amount they are investing in but also with the value of the stocks they are buying.
Value averaging may also be combined with averaging down, if the stock price keeps plunging investors will take advantage of that by lowering their cost basis.
Value averaging example
For example, let's say you want to invest $100 into XYZ stock every month. Over the course of 12 months, the price of XYZ stock fluctuates from $50 to $150 per share. If you use a value averaging strategy, you would invest more money when the stock is cheap and less money when the stock is expensive.
Let's say the stock drops to $50 this month. If the fundamentals of the investment are still strong, you may increase your monthly contribution to $150. This is because you believe it is undervalued.
A few months later, the stock begins to rise to $150. You believe the stock is still a great investment but it is starting to become overvalued. As a value investor, it may go against your philosophy to only put money in undervalued assets.
But as someone that wants to stay consistent and acquire more shares, you may lower your contribution to $50. If you believe the stock was fairly valued at $100, you may invest $100 to match the original monthly contribution. At the end of 12 months, you would have purchased more shares when the stock was cheap and fewer shares when the stock was expensive.
To summarize, value averaging is similar to dollar-cost averaging, except that the amount invested per interval or frequency of the interval is increased when there is an undervalued opportunity.
Conversely, if the asset is overvalued, then either the amount or frequency may be lowered. However, it may not be best to adjust both these variables (amount & frequency).
This is because if you do, it could lead to lump-sum investing or paralysis by analysis. Overall, value averaging is an excellent approach to combining both value investing and dollar-cost averaging.
Advantages and disadvantages of dollar-cost averaging vs value averaging
Now that we know what dollar-cost averaging and value averaging are, let's discuss the advantages and disadvantages of each strategy.
What are the advantages of dollar-cost averaging?
Dollar-cost averaging can help to reduce the effects of market volatility. This is because you are buying securities at regular intervals, regardless of the price. By doing this, you average out your cost per share over time.
DCA can be a good strategy for investors who are risk-averse or who have a limited budget for investing. By buying securities over time, you reduce the chances of losing money if the market takes a sudden turn.
Another advantage is that you can take a hands-off approach with dollar-cost averaging. This means you can pretty much manage your portfolio passively.
It can also help take the emotion and analysis out of investing. This is because you are not trying to time or predict the market.
What are the disadvantages of dollar-cost averaging?
Dollar-cost averaging can sometimes result in you paying more for a security than if you had just bought it all at once. This is because you may be buying the security when it is expensive and selling it when it is cheap.
It can also take a long time to build up a position in a security if you are investing a small amount of money each month. If you are only investing with a traditional dollar-cost averaging strategy, you are missing out on undervalued opportunities.
This strategy is also not very exciting and can be seen as boring by some investors. Although it works, it may not be very exciting to see your portfolio grow slowly over time. This can cause some impatient investors to give up entirely.
What are the advantages of value averaging?
Value averaging can be a good strategy for investors who want to take advantage of market fluctuations. By investing more when prices are low and less when prices are high, you can reduce your overall risk.
You can also take advantage of undervalued opportunities when they arise. By investing more money when prices are low, you can purchase more shares at a discount. It is also flexible which allows you to stay cautious if you believe the market is overvalued.
What are the disadvantages of value averaging?
One disadvantage of value averaging is that it can be difficult to stick to the strategy. If you are investing a fixed sum of money each month, it may be tempting to increase your contribution when the stock is doing well and decrease it when the stock is not doing well.
Although this can work in your favor, it may also backfire if you were wrong. This can lead to continuously investing more and more money into a stock that is destined to fail. It can also prevent you from owning more shares in a company that will continue to rise throughout the decades.
Value averaging helps lower irrational decision-making with fixed intervals or fixed contributions, but there still is some thinking required. If you want to take a more hands-off approach, dollar-cost averaging may be the better strategy for you. Value averaging requires an active portfolio management approach.
Which one should you choose?
To decide which strategy is better for you really depends on your goals and investing style. If you are someone who is risk-averse, dollar-cost averaging may be the better choice. If you do not have a lot of money to invest and earn a steady paycheck, a simple dollar-cost averaging strategy might be best.
This is because value investing requires more money to be able to buy shares when they are undervalued. If you don't have the time to stay involved in the markets or do your own research, dollar-cost averaging can also be a good solution.
If you are consistent with learning about the markets and analyzing stocks, value averaging might be a better fit. If you want to take advantage of market fluctuations or want to purchase more shares when prices are low, value averaging may be the better strategy for you.
It really comes down to what your goals are and how hands-on you want to be with your investments. Whichever strategy you choose, make sure that it aligns with your goals and investment style.
To summarize, dollar-cost averaging (DCA) is an investing technique whereby an investor purchases a fixed number of shares at fixed intervals, regardless of the price. The advantage of dollar-cost averaging is that it takes the emotion out of investing.
Value averaging is an investing technique whereby an investor purchases more shares when the price is low and fewer shares when the price is high. The advantage of value averaging is that it takes advantage of market fluctuations.
Both strategies have their advantages and disadvantages, so it really comes down to what your goals are and how hands-on you want to be with your investments. Whichever strategy you choose, make sure that it aligns with your goals and investment style.