Dollar-cost averaging is a strategy in which a person invests a fixed dollar amount on a regular basis, usually monthly purchase of shares in a mutual fund. When the fund’s price declines, the investor receives slightly more shares for the fixed investment amount, and slightly fewer when the share price is up. It turns out that this strategy results in lowering the average cost slightly, assuming the fund fluctuates up and down.
Value averaging is a strategy in which a person adjusts the amount invested, up or down, to meet a prescribed target. An example should clarify: Suppose you are going to invest $200 per month in a mutual fund, and at the end of the first month, thanks to a decline in the fund’s value, your $200 has shrunk to $190. Then you add in $210 the next month, bringing the value to $400 (2*$200). Similarly, if the fund is worth $430 at the end of the second month, you only put in $170 to bring it up to the $600 target. What happens is that compared to dollar cost averaging, you put in more when prices are down, and less when prices are up.
Dollar-cost averaging takes advantage of the non-linearity of the 1/x curve (for those of you who are more mathematically inclined). Value averaging just goes in a little deeper when the value is down (which implies that prices are down) and in a little less when value is up.
An article in the American Association of Individual Investors showed via computer simulation that value averaging would outperform dollar- cost averaging about 95% of the time. “Outperform” is a rather vague term. As best as I remember, whatever the percentage gain of dollar- cost averaging versus buying 100% initially, value averaging would produce another 2 percent or so.
Warning: Neither approach will bail you out of a declining market with all of your monies intact, nor get you fully invested in the earliest stage of a bull market.
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Contributed-By: Maurice Suhre