Is it a better alternative to DCA?
The strategy of dollar-cost averaging (DCA) is probably not foreign to most retail investors. We commit a fixed sum over a period of time instead of committing an initial lump sum. By doing so, we are able to:
Reduce the impact of volatility on the overall investment
Remove the need to time the market
Purchase more shares when the prices are down, and less when the prices are up.
However, there is actually another strategy similar to DCA - Value Averaging (VA).
It is similar to DCA in that we still invest across a period. What distinguishes this from DCA is the amount we invest each month.
Value averaging (VA) is a concept introduced in 1988 by Michael Edleson, who later wrote a book on it in 1993.
Similar to DCA, VA is a formula-based approach where you set an amount to invest in over a period. For example:
For DCA, you would perhaps set aside a fixed $200 per month to invest.
For VA, you adjust this amount depending on how your portfolio performed in the previous period.
Let's go through an example. Let's say you want to increase the value of your portfolio by $200 per month. You currently have $2,000 in an asset.
If the investment value increased to $2,024, you only invest $176 (200 - 24) to ensure that your account only increases to $2,200.
However, if your investment value decreased to $1,900, you would invest $210 (200 + 10) to ensure that the account increases to $2,200.
You'll maintain this strategy for subsequent periods until you reach your investment objective.
So what does this do?
Well, the goal of this method is to acquire even more shares when the prices are low, and fewer shares when the prices are high, relative to DCA.
When the portfolio underperforms, you need to invest a larger amount to 'top-up' the portfolio.
Conversely, when the portfolio outperforms the expected growth, you'll simply invest a smaller amount, or even sell off some shares to maintain the current growth rate. The amount received from selling off shares or not investing can then be used as a buffer for when the portfolio underperforms.
For retail investors, this is another strategy we can consider when saving up for big-ticket items.
When the markets are overvalued, the amount received from selling off shares or not investing can be placed in relatively safer investments like cash management accounts to continue to earn some returns.
Hence, even when the market declines when our investment objective is nearing its end, we still have this buffer that can help cushion the impact.
Let's now do a brief comparison to see how VA fares compared to DCA, assuming that the investment objective is $5,000 after 5 periods.
A rise followed by a fall
A fall followed by a rise
It really depends. If you're okay with some level of downside risk, then perhaps DCA might be a better alternative since the market always trends upwards, and you own more shares compared to VA in a rising market.
VA seems to be a strategy more suited when the market is volatile, allowing you to purchase more shares when they are at a discount and fewer shares when they are overvalued and due for a pullback.
As with every investment strategy, VA comes with some limitations.
Limitation 1: Difficult to time entry/exit via a robo-advisor
Limitation 2: Need to take into account other costs
Limitation 3: Need to be able to commit in a declining market
Limitation 4: Assumes that the market eventually trends upwards.
Whether you should value average or dollar cost average really depends on your investment objectives.
VA is a possible strategy you can consider if you are okay with actively buying/selling every period. Otherwise, DCA works if you just want to passively set aside a sum of money every period.
Alternatively, you can continue to DCA and pump in more money when there is a downturn or correction, which some in the community are already doing. This way, you still buy even more shares when the prices are low. This is also probably the more fuss-free approach.
DISCLAIMER: Opinions expressed here are my own. What may work for one person may not be applicable to another. Do your own due diligence.
View 1 other comments