Dollar Cost Averaging VS Value Averaging

Part One:

Introduction

Think of a situation, where an investor has found a value stock to invest and the market price of the stock is favourable to purchase with a proper margin of safety. When he is about to purchase the stock, the market becomes volatile. The question then arises in front of the investor: what will be the process of purchasing the stock? Should he purchase the stock at once or use the dollar cost averaging tactic or something called the value averaging tactic??This writing is all about a try to find the solution to this purchasing process in a volatile market.

What is Dollar Cost Averaging (DCA)?

Dollar-cost averaging (DCA) is a simple and well-used strategy by many investors around the world. It is a tactic to reduce the impact of volatility on large purchases.?Dollar-cost averaging is also called the?constant dollar plan?(in the?US),?pound-cost averaging?(in the?UK), and, irrespective of currency, unit cost averaging?or the?cost average effect.

The DCA strategy is founded on a simple rule: Invest the same amount of money each period, regardless of the price. Sticking to the formula means that investors avoid the nervous selling during market panics that leave so many individual investors on the sidelines later during the inevitable upward turns coming out of a down market. The DCA strategy invests a fixed amount at regular intervals (every month for many investors), regardless of market price. Because investors end up buying shares at various prices, they get fewer shares when prices are high and more shares when prices are low. This is in line with our natural desire to buy low and is contrary to most investors’ natural reaction to market levels (e.g., to buy high). [1]

Example:

The following example is a purchase of XYZ stock from January 2018 to June 2018. Every month 500 dollars of stock is purchased regardless of price. When the price is low, $500 brings more shares and when the price is high, that brings fewer shares.

What is Value Averaging (VA)?

Value averaging (VA), also known as?dollar value averaging (DVA), is a technique for adding to an investment?portfolio?that is claimed to provide a greater return than other methods such as?dollar cost averaging?(DCA). Instead of a “fixed dollar” rule as with dollar cost averaging (“buy $500 more stock each month”), the rule under value averaging is to make the value of your stock holdings go up by $500 (or some other amount) each month. This is a very simple version of the strategy, to be enhanced later, but the focus on resulting value instead of on investment cost is the main point. [2]

Value averaging has been presented as an alternative method of accumulating market wealth over time. By focusing on a predetermined value goal that increases over time, investors can take the dollar cost averaging philosophy of “buy more cheap shares” a step further. Returns are generally higher with value averaging, and there is not much downside return risk relative to dollar cost averaging. The features of value averaging make it more flexible but also more complicated than dollar cost averaging. [3]

Example:

Compared with the same example of DCA, it is observed that VA has given lower average cost and greater return. Again, the VA investor had to sell 22 shares in April 2018 because the target value had crossed by $102 from $2000, VA strategy instructed to sell the extra amount of shares.

Let’s twist a bit:

DCA and VA are mainly introduced for index funds. It is like DPS in our country: every month investor keeps investing a certain amount of money for 3-5 years. But, users of DCA or VA should know that it works better in the short term and intermediate term, not for the long term.

My tactic of using DCA/VA is a bit different from the traditional one. After selecting a deeply undervalued stock and allocating a certain amount of money to purchase the stock, I set a timeline to purchase it. Suppose, I have selected the next 6 months to purchase the stock, which I have planned for holding 3-5 years. This 6 months for purchasing the stock gives me room to mitigate the volatile price movement and a better average purchase price.

Part Two:

“Stop trying to predict the direction of the stock market, the economy or elections.”

-- Warren Buffett

“Nobody can predict interest rates, the future direction of the economy or the stock market. Dismiss all such forecasts and concentrate on what’s actually happening to the companies in which you’ve invested.”

-- Peter Lynch

Predicting market directions is a dangerous task. Nobody knows the actual direction of the market near future. Whatever the forecaster says about the market direction, it is nothing but a personal viewpoint which has built-in 50-50 probability. When an investor thinks of buying a stock, he doesn’t know if the current price is the lowest price or price may fall further. Here, the importance of dollar cost averaging (DCA) or value averaging (VA) comes. (DCA/ VA are well explained in my previous article.)

Investors can select stocks by value investment strategies or anything else, but purchasing stocks can be done using DCA or VA. I suggest a 6-month spread between starts and ends of purchasing. Every month in a particular week purchase operation can be done no matter what the price is. This purchase could give a better average price.??

Tactic form technical analysis can also be used to get better results from DCA or VA. Technical analysis says the price moves on trend, though it is not well believed by the fundamental analyst, but most of the time price stalls near the support /resistance zone. If the investor plans to buy a stock within the coming 6 months, purchasing the stock near the support zone is a better idea than fixing only the week of purchasing. Every month buying near the support zone will give a better average price than buying on a particular week in either conditions - market moving upwards or market moving downwards.

The classical method of using DCA and VA to purchase stocks is enough to get a better average price. I have just added two additional methods of doing the same. Here I just tried to shed light on this tactic from my point of view and so tactics of purchasing stock might differ from investor to investor.

Reference:

1.?Edleson, Michael E. (2007). ‘Dollar Cost Averaging Revisited’. Value Averaging: The Safe and Easy Strategy for Higher Investment Returns. New Jersey. John Wiley & Sons, pp. 25-38.

2.?Edleson, Michael E. (2007). ‘Value Averaging’. Value Averaging: The Safe and Easy Strategy for Higher Investment Returns. New Jersey. John Wiley & Sons, pp. 39-40.

3.?Edleson, Michael E. (2007). ‘Value Averaging’. Value Averaging: The Safe and Easy Strategy for Higher Investment Returns. New Jersey. John Wiley & Sons, pp. 55-56.

This is just the online version of the main article published in “Portfolio”, a quarterly magazine of the Chittagong Stock Exchange. "Part One" was published in the March- June 2019 edition and "Part Two" was published in the July- Sep 2019 edition.