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Dollar-cost averaging (DCA) is a popular investment strategy, but is it better than value averaging or investing a lump sum?
Each method comes with its own pluses and minuses. In some cases, one approach is better than the other. It all depends on your investment time-frame, personal preference, and even your portfolio.
How much and how often you invest can have a significant impact on your long-term profits.
You should choose the strategy that works best for you. To help you decide, we’ll go over all the benefits and disadvantages of dollar-cost averaging, value averaging, and lump-sum investing.
What Is Dollar-Cost Averaging? (DCA)
Dollar-cost averaging (DCA) is a simple investment strategy that involves investing a specific amount of money on a predetermined schedule. For example, investing $100 every week is a way to dollar-cost average your investments.
DCA is simply spreading out a large sum of money and making smaller periodic investments instead of investing it all at once.
When dollar-cost averaging, you always invest your scheduled amount regardless if the market is up or down, this way you can take advantage of down days.
You may already be dollar-cost averaging with your 401(k) contributions.
Benefits of Dollar-Cost Averaging
- Keeps you from trying to time the market. It’s nearly impossible to time the market. Dollar-cost averaging makes sure that you’re investing regularly, regardless of asset prices.
- Lowers your risk. Your keeping money out of the market instead of going all in. DCA makes you less vulnerable to a market crash, making it a more conservative investing approach.
- Makes it easier to diversify. If you have less money saved up, you can still afford to invest small amounts over time.
- Your set investment amount buys more shares when the market is down and less when it is up, so it averages out.
- Takes some of the emotion out of investing.
Disadvantages of Dollar-Cost Averaging
- Typically, the market is always rising. Many argue that you will miss out on gains if you choose to dollar-cost average instead of investing a lump sum.
- You can be on auto-pilot for too long. Investors that dollar-cost average tend to go too long without reviewing their portfolio and rebalancing when necessary.
What Is Value Averaging?
Value averaging is a dollar-cost averaging strategy with some additional steps.
With value averaging, you increase your investment to purchase more shares when the price falls and invest less money when the price rises.
Sounds easy, but it’s actually a bit more complicated. You will need to set a target growth rate and make adjustments to your investment amount.
For example, let’s say you want your portfolio to grow $200 every month. After your first investment, your portfolio is worth $225. Instead of investing another $200, you will invest $175; this way, you hit your target for the 2nd month, which would be a balance of $400.
The $25 that you planned on investing can sit in an interest-bearing cash account like a money market fund.
Now let’s say the market goes down the next month, and your portfolio decreases to $375, you will invest $225 to meet the $600 target balance for the 3rd month. The $25 you didn’t invest last month is added on top of your regular $200 investment.
If the market rises substantially, you may even sell shares to stay within your growth target.
Benefits of Value Averaging
- You are investing more when the market is depressed.
- Better probability of producing higher returns.
- You are paying more attention to the market, your portfolio, and investment targets.
Disadvantages of Value Averaging
- More complicated and more work.
- If you need to sell shares, you will have to pay capital gains tax.
- In a down market, you may run out of money to keep up with your target.
- You can end up holding too much cash while the market rises.
What Is Lump-Sum Investing?
Lump-sum investing is investing a large amount of money all at once instead of breaking your investments into small amounts.
It’s a common investing method for those who have received a windfall or large inheritance.
Benefits of Investing a Lump Sum
- Your money is put to work immediately.
- You take full advantage of a rising market.
- Straightforward strategy and easy to do.
- A favorite method of long-term investors.
- Maximizes your potential returns.
Disadvantages of Investing a Lump Sum
- Harder to stomach; makes it easier to get emotional.
- Can maximize losses if invested at the top of an overpriced market.
- Investors are more likely to try and time the market, which can diminish potential returns.
Dollar-Cost Averaging vs Value Averaging
Both dollar-cost averaging and value averaging involve investing specific amounts at regularly scheduled times.
Value averaging is argued to produce better returns than dollar-cost averaging but isn’t easily proven.
Value averaging can beat dollar-cost averaging for those who are specific about their targets and want to invest more when prices are depressed.
Dollar-cost averaging is better for those looking for a simple approach.
Value Averaging vs Lump Sum
Value averaging is a more sophisticated approach than investing a lump sum. One is not necessarily better than the other.
You could invest a large sum right before the market dramatically falls and takes a long time to recover; value averaging would be a better strategy in this case.
If you invest a lump sum and the market continues to rise like it usually does, you could potentially beat the returns of those who are value averaging their investments.
Dollar-Cost Averaging vs Lump Sum
Not everyone is fortunate enough to have large sums of money that they do not need for other necessities.
Dollar-cost averaging makes it possible for people to start small and compound their wealth.
Depending on what cyclical stage the market is in, DCA may be a better option than investing a lump sum.
Dollar-cost averaging is likely a better choice during a bear market or when PE ratios are exceptionally high.
Lump-sum investors will just need to close their eyes and hope they’ve either caught the bottom or avoided a market top.
The popular 2012 Vanguard study, states investing a lump-sum produces better returns than dollar-cost averaging about 66% of the time.
Lump-sum investing is commonly praised as the better choice, but keep in mind past market performance does not always indicate future performance.
For those that believe the market will always go up over time, I ask them to look at Japan. It’s been over 30 years since Nikkei’s market peak, investors that invested a lump sum at that time have still not broken even.