Dollar Cost Averaging vs Value Averaging

I suspect most have heard of dollar cost averaging (DCA), but for those who haven't, I will offer a brief explanation.  DCA is a method of investing a fixed amount of money at regular intervals into a mutual fund, stock, or other type of investment.  The result is that when prices are low, you buy more of the investment, and when prices are higher, you purchase less.  This lowers your overall basis in the fund and can increase the likelihood that your average purchase price is lower than it might otherwise be had you purchased a lump sum investment.

Example:  You decide to invest $300 in mutual fund ABC for 3 months.  It is currently priced at $10, so you buy 30 shares.  Next month the price is $5, so you pick up 60 shares.  It then rebounds back to $10, and you get another 30 shares.  The result of your $900 investment is that you purchased 120 shares which are now worth $1200, a 33% profit.  Had you invested all $900 at once, you would have purchased 90 shares and would be even. 

Fewer people have heard of value averaging.  Value averaging means that the investor decides the value that the investment should have at each point in time and then adjusts the amount of the investment to match that value.  If we go back to the mutual fund ABC example, the investor has decided that he wants the value to increase by $300 each month for 3 months.  We know what the value will be, but how do we get there?  Let's look:

The first month, fund ABC is at $10 so the investor buys 30 shares for a value of $300.  So far, so good.  Month 2 ABC is at $5.  The total value should be $600.  The value of the shares already owned is $150 (30 x 5), so the investor has to invest $450 this month and purchases 90 more shares.  As above, the fund rebounds to $10 the final month.  The value should now be $900.  Well, the investor has 120 shares worth $1200.  What to do?  Value averaging would actually have the investor sell 30 shares to get the value back down to $900 total.  The end result is that the net investment is $450, and the value is $900 for a profit of 50% vs 33% for DCA.

DCA is great if you have a fixed amount of money that you will be investing over time, for example in a retirement or college savings plan.  Value averaging can also be used, but you should have access to some additional funds for times when the required investment is higher because prices are down.  After some time, the funds are available because you have sold when prices are higher.

As you may have noticed, value averaging does a much better job of forcing the investor to buy low and sell high.  DCA does not have any sell provision so the investor is left to guess as to when might be the best time to sell.  Over longer periods of time, value averaging will have better performance than DCA 95% of the time.  There can be tax implications if you sell in a non-tax advantaged account.  In taxable accounts, you might consider avoiding the sell provision and just carry out the value without investing until you need to add money again.

But, if used in an IRA or 401(k), value averaging can force you to sell near the market tops and increase your investments near the bottom which is a major advantage vs buying and holding watching the value rise and fall like a roller coaster.  You should consider value averaging as a tool for managing your investment portfolio.