Back to the Basics: Dollar-Cost Averaging & Value Cost Averaging

Keith Fitz-Gerald Jul 07, 2017

Millions of investors are familiar with the concept of “dollar-cost averaging” – meaning that they buy a fixed dollar amount of something regularly over time regardless of share price.

Today I want to share a Total Wealth Tactic that can help you build bigger profits faster.

In case you are not familiar with the term “dollar-cost averaging,” it’s simply a means of accumulating investment assets by buying the same dollar amount of shares at some predetermined regular interval, regardless of the market price at that time.

Using this tactic ensures that you’re always buying low when an opportunity arises.

I like it because buying more shares at lower prices and buying fewer shares at higher prices is a big win over time.

Doing so harnesses the natural ebb and flow of prices, which means that you’ll wind up with higher profits down the line as a company matures and more investors pile in as the price goes up.

How It Works

This is an especially good tactic to use on stocks you might otherwise think are “too expensive” for your retirement – think Apple Inc. (NasdaqGS:AAPL), Alphabet Inc. (NasdaqGS:GOOGL), and Amazon.com Inc. (NasdaqGS:AMZN).

Imagine you automatically send $300 each month toward a stock, let’s call it XYZ, for your retirement fund. It’s April and shares of the stock are trading at $50 per share. Your automatic purchase of $300 worth translates into six shares:

$300 ÷ $50.00 = 6 Shares

In May, perhaps there is geopolitical tension that drives the stock down to $30. But, in sticking to your disciplined approach, you still devote $300 as planned. This time, your automatic $300 purchase translates into ten shares:

$300 ÷ $30.00 = 10 Shares

The following month, it trades at $46.15. You automatically devote another $300 and purchase 6.5 shares:

$300 ÷ $46.15 = 6.5 Shares

By July, let’s say that there’s a rally and the stock hits $54.50 per share. You automatically pick up another 5.5 shares:

$300 ÷ $54.50 = 5.5 Shares

After your July purchase, you’re sitting on 28 shares for an average buying price of $42.85 per share. In total, you spent $1,200 ($300×4).

Now, consider if you had instead spent all that $1,200 in one go back in April.

$1,200 total investment ÷ $50.00 per share = 24 Shares

What I like about dollar-cost averaging it that it helps keep risks low yet returns high, because it prevents you from investing a single large amount at the wrong time… like now, for example, if you’re one of millions of investors worried prices could drop further.

I’m also a big fan of the discipline dollar-cost averaging instills because it takes emotion out of the equation.

And finally, dollar-cost averaging forces you to buy more shares when prices are low, while fewer shares are purchased when prices are high. Over time, your basis – a fancy way of saying your total cost – actually drops and that, in turn, means you have that much more upside.

Here’s an example…

Imagine investing $10,000 into Apple in September 2008.

You’d be sitting on 421 shares worth only $5,313 as of March, 3, 2009, when people thought the end of the financial universe was upon us.

Had you dollar-cost averaged in for three months starting that same September, though, your holdings would be sitting on 581 shares worth $7,333 on the same day. Both are losses and that’s no fun.

Here’s where it gets interesting – and very profitable.

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Apple would have to rise only $4 per share for you to break even if you’d dollar-cost averaged in, versus needing gains of $11 per share for you to break even if you went all in.

More to the point, 12 months later you’d be sitting on profits of 37.98% because of dollar-cost averaging versus barely breaking even had you invested all at once.

I think that’s a powerful and very compelling performance advantage that capitalizes on your skepticism yet keeps you in the game…

…even if stocks still have a ways to go before they find another bottom.

Now for the good stuff.

Value Averaging

Value averaging is a little different. Not many investors know about it which is too bad considering how valuable – pun absolutely intended – this Total Wealth Tactic is.

Dollar-cost averaging would have you invest $300 a month, but you might prefer to grow your portfolio by a fixed amount every month.

For discussion purposes, let’s assume that you want to make your portfolio grow by $300 a month – every month.

In some months, you’d invest $300 just as with dollar-cost averaging. However, if the $300 you contributed last month lost a bit of ground and is now only worth $290, you’d contribute $310 next month to make up the difference.

In the months where you’ve made more than your target, you have the option not to contribute anything at all.

This simple twist first proposed by its creator, former Nasdaq Chief Economist and Harvard Business School Professor Michael E. Edleson, has been shown to produce better results over time than the conventional dollar-cost averaging method.

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Edleson, who is now the Chief Risk Officer for the University of Chicago’s endowment, relied on one crucial piece of information that was missing from the dollar-cost averaging method to come up with “value averaging.” By considering a portfolio’s expected rate of return [something that the dollar-cost averaging method neglects], the “value averaging” method helps to identify periods of over- and underperformance.

When the portfolio is underperforming, share prices are likely to be low. And that’s when you’ll be investing more to make up for the underperformance. When the portfolio is outperforming your target-rate return, share prices are likely to be high. That means it is not a good time to buy and you could even sell for a profit, provided you maintain your predetermined average growth rate.

Again… the herd gets it wrong but these Total Wealth Tactics will ensure you get it right.

“Value averaging” is a nice – and very easy – way to ensure you follow one of the most well-known investment mandates:

Buy low and sell high.

The method is particularly valuable during times of high volatility to help ensure investors maintain discipline in their investing.

I’ll be back next Friday with another valuable tactic…

In the meantime, read more About Dollar-Cost Averaging here.

Keith

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