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Dollar Cost Averaging vs. Value Averaging

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Last week I wrote about the pros and cons of dollar cost averaging. It is not a perfect method of investing, but it has its benefits – it is easy to set up and takes very little upkeep. While most people are familiar with dollar cost averaging, there is a similar investment strategy called dollar value averaging, or simply value averaging. Here is a comparison to the two investment methods:

Dollar Cost Averaging vs. Value Averaging

Dollar cost averaging (DCA). Dollar cost averaging is the method of investing the same amount of money at set intervals, regardless of share price. A good example would be bi-monthly contributions to a retirement plan such as a 401k or IRA. With dollar cost averaging, a steady contribution will buy more shares when prices are low, and fewer shares when prices are high. This takes the guess work out of systematic investing, and smoothes the average purchase price for your shares.

Value averaging (VA). A similar investing technique is value averaging, which involves changing your periodic investment contributions. With value averaging, you start with the end goal in mind and work toward a target number. Let’s say you have a target portfolio value of $12,000 by year end, which means you need to grow your portfolio by $1,000 per month. You contribute $1,000 the first month, then make subsequent contributions based on the total portfolio amount. If in the second month the value of your shares drops to $900, you would contribute $1,100 to bring the total value of the portfolio to $2,000. If the value of the shares rose to $1,100, you would only need to contribute $900 to bring the value of the portfolio to $2,000.

How is value averaging different from dollar cost averaging? With DCA you always contribute the same amount of money, so you buy more shares when prices are low only because the shares cost less. With VA you buy more shares because the prices are lower and you contribute more money. Conversely, with VA you buy fewer shares when prices are higher because share prices are higher and you contribute less money.  In effect, it gives you more bang for your buck.

Pros and cons of value averaging

The main benefit of value averaging is that it forces investors to contribute less money when prices are high, and contribute more money when prices are low, as opposed to dollar cost averaging, which uses the same contribution regardless of share price. Value averaging can actually have better results in the long run because you contribute more money when shares are lower. To employ correctly, value averaging also requires investors to know where they stand in regard to reaching your investment goal, which is another added benefit.

There are several disadvantages of value averaging. Value averaging takes more time than DCA, which basically runs on auto-pilot once you start it. Another disadvantage is when share prices fall so much that it takes very large investments to bring many portfolios back up to the goal. The current market would be a good example of this.

Neither dollar cost averaging or value averaging is perfect

Contributing to investments using dollar cost averaging or value averaging does not guarantee returns. But they both provide a system to follow, and promote disciplined investing. And disciplined contributions are a key to reaching your financial goals.

More information about value averaging. Dollar Value Averaging was developed by former Harvard professor, Michael E. Edleson. This investment technique was introduced in his book, Value Averaging: The Safe and Easy Strategy for Higher Investment Returns.


Published or updated January 18, 2010.
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{ 9 comments… read them below or add one }

1 Laura K

Thanks for the explanation. What do you think about increasing 401k contributions when the market’s doing poorly and lowering them back to normal levels as it gains, provided you are still contributing as much as you originally planned for the year?

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2 Donny Gamble

A lot of people who just put money into their roth ira’s or mutual funds don’t really implement these two system currently. They just put their money in the most profitable mutual fund that has been giving the highest rate of return. They almost never choose the proper fund that they should choose.

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3 Jarhead

Couldn’t value averaging make you invest more or less depending on the market then you plan?

I.E. I you start with $1000 in Jan and you want it to average $1000 /month if the market falls every month. Or if it goes up every month you are only putting in 800-900.

Or do I stop when I hit my limit or contribute more if I haven’t reached my limit?

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4 Ryan

Laura: I think that could bring in better returns over the long run, but you need to keep in mind that it may take a couple weeks for the changes in your 401(k) to take effect (while waiting for the next pay period).

Donny G: Good point – and definitely not the way to go. I just go after asset allocation coupled with low fees.

Jarhead: Yes and no. If you follow value averaging by the book, there could be times when you don’t contribute anything, or times when you contribute multiples of your normal contribution. I don’t think it is something I would follow to the letter, but in times when the entire market is down (such as now), I would consider upping my contributions if I could afford it.

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5 Alisa

Thank you for the insight. I guess as an investor you have to really monitor the performance of your portfolio and decide what works best for you. Be well.

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6 Dividend Growth Investor

I guess with value averaging you try to time the market by trying to buy low and not buy when it’s high. The problem is that during bull markets the prices only keep getting higher.. And in bear markets the prices keep getting lower.

I think that dollar cost averaging should work best for most people. Just set it, put it on autopilot and forget it.

My man from disciplined investing just published an article about returns of investors who time mutual funds versus buy and hold a simple index fund..

http://disciplinedinvesting.blogspot.com/2008/10/market-timing-dangers.html

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7 Writer's Coin

Interesting alternative to DCA—I had never heard of it. While it does come across as market timing in sheep’s clothing, there is something “automatic” to it that keeps it from feeling like market timing. Definitely worth a shot.

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8 Writer's Coin

This is a great resource for those that want to read more and see the plans in action:

http://www.studyfinance.com/jfsd/pdffiles/v13n1/marshall.pdf

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9 Budgets are Sexy

Great post! I never hear of “Value averaging” all that much, so it was cool to read about something new to me. well put :)

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