Friday, December 3, 2010

Dollar-Cost Averaging vs. Value Averaging

From Fox Business News.

For those of you who don't know what we're talking about: "For those not familiar with the term, dollar cost averaging involves investing equal dollar amounts into an investment vehicle at specified intervals. You can dollar cost average on pretty much any timescale – weekly, monthly, quarterly, and so on.

With dollar cost averaging, the number of shares that you wind up buying varies depending on the price of the underlying investment. Let’s say you buy $100 worth of a certain index fund with each paycheck. If the share price is $20 one pay period, you’ll get five shares. If the price climbs to $25 the next pay period, you’ll get four shares.

The “magic” of dollar cost averaging is that you wind up buying more shares when prices are down and fewer shares when prices are up. Dollar cost averaging is also a good risk strategy for reducing risk, as you’ll never go “all in” at the top of the market."

Value Averaging goes like this: "Value averaging is a strategy for investing more money when an investment’s price (value) is low, and less when the price is high, based on an end goal you’ve set. Sound vague? Let me share a simple example to give you an idea of how it works.

Let’s say you’re starting a new investment portfolio in 2011, and your goal is for the value of this portfolio to be $5000 by the end of the year. That comes out to approximately $416/month, so you go ahead and contribute that amount in January.

When February rolls around, you see that your portfolio has decreased a bit due to a down market. It’s now worth $316 ($100 below the initial value). With value averaging, you’d contribute $516 (an extra $100) that month to stay on target for your goal.

Now let’s assume that the market rebounds, and your portfolio jumps to $1,000 the following month. To compensate, you only invest $248 that month, as prices have risen closer to your target value for that point in the year.

You would then continue adjusting throughout the year based on market fluctuations.

The advantage here is that you’re investing more money (vs. just getting more shares for your money) when prices are down, and investing less money when prices are up.

As you can see from the example, value averaging can give you better returns compared to dollar cost averaging since you’re investing more money in when the prices are down and less when they’re up.

On shortcoming of this approach is that, in a declining market, it’s possible that you’ll actually run out of money and be unable to keep up with the additional contributions required to stay on track. This is especially problematic as the value of your portfolio grows, as the swings can be quite large in terms of dollar amounts.

Another interesting angle is that if your portfolio “overperforms” this strategy would actually have you pull money out of the market. This equates to selling high, which is generally a good thing, but it’s not something that people are used to doing.

Probably the biggest challenge with this approach is to continue increasing your contributions in the face of a deteriorating market. But if you throw in the towel, you’ve effectively changed investment strategy, and are now trying to time the market based on your gut instincts."

Too bad many employer-based retirement arrangements won't let you value average, as they're set up for a set dollar amount automatic deduction. From looking at the last paragraph above, the value averaging method basically has YOU making up for market losses and downturns--not many of us can afford to do that.

Something tells me that the term "value averaging" is just another name for bear-market investing, or value investing, but I can't seem to prove it at this time.


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