Choosing Between Dollar-Cost and Value Averaging (2024)

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).

Key Takeaways

  • Dollar-cost averaging is a practice wherein an investor allocates 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, rather than for bonds or CDs.
  • Dollar-cost averaging is a good strategy for investors with lower risk tolerance since putting a lump sum of money into the market all at once can run the risk of buying at a peak, which can be unsettling if prices fall.
  • Value averaging aims to invest more when the share price falls and less when the share price rises.
  • Instead of investing a set amount each period, a value averaging strategy makes investments based on the total size of the portfolio at each point.

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 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.

Value Averaging

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 (andat a lower level of risk).

In certain circ*mstances, 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, VA investors buy more shares because prices are lower, and the strategy ensures that the bulk of investments is 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. In addition to purchasing shares at set intervals when using DCA, if the stocks you are purchasing happen to pay dividends as well, you can 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.

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.

Investopedia does not provide tax, investment, or financial services and advice. The information is presented without consideration of the investment objectives, risk tolerance, or financial circ*mstances of any specific investor and might not be suitable for all investors. Investing involves risk, including the possible loss of principal. Investors should consider engaging a qualified financial professional to determine a suitable investment strategy.

Choosing Between Dollar-Cost and Value Averaging (2024)

FAQs

Choosing Between Dollar-Cost and Value Averaging? ›

Dollar-cost averaging

Dollar-cost averaging
Dollar-cost averaging involves investing the same amount of money in a target security at regular intervals over a certain period of time, regardless of price. By using dollar-cost averaging, investors may lower their average cost per share and reduce the impact of volatility on the their portfolios. 1.
https://www.investopedia.com › terms › dollarcostaveraging
is a good strategy for investors with lower risk tolerance since putting a lump sum of money into the market all at once can run the risk of buying at a peak, which can be unsettling if prices fall. Value averaging aims to invest more when the share price falls and less when the share price rises.

Is value averaging better than dollar-cost averaging? ›

Several independent studies have shown that over multiyear periods, value averaging can produce slightly superior returns to dollar-cost averaging, although both will closely resemble market returns over the same period.

Why i don t recommend dollar-cost averaging? ›

The Market Rises Over Time

If you don't increase your monthly investment over time, you may end up with fewer and fewer shares on average. If you can afford to make a lump-sum investment instead of dollar cost averaging, you could come out ahead if your timing is right.

Is DCA the best strategy? ›

A third of the time, dollar cost averaging outperformed lump sum investing. Because it's impossible to predict future market drops, dollar cost averaging offers solid returns while reducing the risk you end up in the 33.33% of cases where lump sum investing falters.

Is it better to DCA or lump sum? ›

The lump-sum strategy came out on top in each time period. This is because markets generally rise over time. So the DCA investor often bought in at higher average prices. While this data is helpful, many of us do not make decisions based solely on stats and figures.

What are the 2 drawbacks to dollar-cost averaging? ›

Pros and cons of dollar-cost averaging
  • Dollar-cost averaging can help you manage risk.
  • This strategy involves making regular investments with the same or similar amount of money each time.
  • It does not prevent losses, and it may lead to forgoing some return potential.

What are the 3 benefits of dollar-cost averaging? ›

Benefits of Dollar-Cost Averaging

It's automatic and can take concerns about when to invest out of your hands. It removes the pitfalls of market timing, such as buying only when prices have already risen. It can ensure that you're already in the market and ready to buy when events send prices higher.

Why do you think dollar-cost averaging reduces investor regret? ›

Dollar-cost averaging makes it easier to stick to the plan

In hindsight, after the market has recovered, investors often regret not taking advantage of what they now know to be a great buying opportunity.

How often should you buy stocks for dollar-cost averaging? ›

Consistency trumps timing

It sounds technical, but dollar cost averaging is quite simple: you invest a consistent amount, week after week, month after month (think payroll contributions going into your 401(k) account) regardless of whether the markets are up, down or sideways.

Does dollar-cost averaging guarantee against loss? ›

Nothing's a Guarantee, Of Course

As with everything in investing, DCA is not without its detractors. Dollar-cost averaging can underperform lump-sum investing at times. But while systematic investing does not guarantee a profit or protect against loss, it can lift a psychological brick or two off your shoulders.

What are the pros and cons of dollar-cost averaging DCA? ›

The advantages of dollar-cost averaging include reducing emotional reactions and minimizing the impact of bad market timing. A disadvantage of dollar-cost averaging includes missing out on higher returns over the long term.

What is DCA advantages and disadvantages? ›

Advantages and Disadvantages of BCA Course
Advantages of BCA CourseDisadvantages of BCA Course
Early Entry to IT FieldLimited Specialisation
Practical Skill DevelopmentCompetitive Job Market
Strong Foundation in Computer ScienceRapidly Changing Technology
Diverse Career OpportunitiesHeavy Workload
6 more rows
Sep 28, 2023

What are 5 benefits of DCA? ›

Benefits of DCA Course
  • Improve Your Computer Skills. Discover efficient computer use for common activities. ...
  • Career Advancement. ...
  • Versatility. ...
  • Time and Money Efficient. ...
  • Practical Education. ...
  • Personal and professional purposes. ...
  • Maintain Current. ...
  • Opportunities for Self-Employment.
Sep 28, 2023

What is dollar-cost averaging Warren Buffett? ›

Buffett was essentially saying that when accumulating investments, be more aggressive when prices are low and less aggressive when they're high. That's dollar cost averaging in a nutshell.

What is the best investment for $100,000? ›

6 approaches and strategies to invest $100,000
  • Park your cash in an interest-bearing savings account.
  • Max out contributions to retirement accounts.
  • Invest in ETFs.
  • Buy bonds.
  • Consider alternative investments.
  • Invest in real estate.
Apr 3, 2024

Is it better to invest annually or monthly? ›

Even in a strong economy, the market fluctuates daily. Monthly investors are better placed to smooth out this volatility. A compromise could be to invest your lump sum in stages, for example over six months or a year.

What is the difference between dollar-cost averaging and value averaging? ›

With value averaging, you're using the value of your portfolio and your investment goals as a guide for calculating monthly contributions. Dollar-cost averaging, on the other hand, has you invest the same amount of money each month, regardless of your portfolio's value.

What is the difference between dollar-cost averaging and value cost averaging? ›

Dollar-cost averaging is a good strategy for investors with lower risk tolerance since putting a lump sum of money into the market all at once can run the risk of buying at a peak, which can be unsettling if prices fall. Value averaging aims to invest more when the share price falls and less when the share price rises.

Is buying dips better than DCA? ›

Deciding between dollar cost averaging vs buying the dip ultimately hinges on your risk tolerance, investment goals, and engagement level with the market. While DCA provides a steady, lower-risk path, buying the dip offers the potential for greater returns, demanding more attention and risk acceptance.

Why is lump sum better than dollar-cost averaging? ›

Some analysis suggests that dollar-cost averaging is approximately equivalent to an asset allocation where only 50 to 65 per cent of the portfolio is invested in risky assets and the rest in riskless assets – such as treasury bills – is still suboptimal compared with a lump sum investment into a portfolio with those ...

Top Articles
Latest Posts
Article information

Author: Madonna Wisozk

Last Updated:

Views: 5535

Rating: 4.8 / 5 (68 voted)

Reviews: 91% of readers found this page helpful

Author information

Name: Madonna Wisozk

Birthday: 2001-02-23

Address: 656 Gerhold Summit, Sidneyberg, FL 78179-2512

Phone: +6742282696652

Job: Customer Banking Liaison

Hobby: Flower arranging, Yo-yoing, Tai chi, Rowing, Macrame, Urban exploration, Knife making

Introduction: My name is Madonna Wisozk, I am a attractive, healthy, thoughtful, faithful, open, vivacious, zany person who loves writing and wants to share my knowledge and understanding with you.