A Better Alternative to Dollar Cost Averaging
Welcome to this post about “A Better Alternative to Dollar Cost Averaging”!
Last year in March of 2020, the stock market took a hit. The market collapsed roughly 50% in a matter of weeks. I knew it was a once in a lifetime chance to buy, so I tried to invest as much money as I could. I’ve had some pretty nice returns since then.
So recently I started wondering, what if instead of consistently investing in the form of dollar cost averaging, you held on to your money for times when the market turns red.
Everyone knows the phrase, “Buy Low Sell High”. But, what if you took that to an extreme and ONLY bought when the market dropped and then sold someday in the future when the market should be much higher.
I was curious if there was a strategy that worked better than dollar cost averaging. So I did what any finance nerd would do…I opened up some spreadsheets and started playing around.
I was able to create some strategies on my own that came very close to having the same returns as dollar cost averaging. After some internet research, I stumbled upon a strategy called value averaging which was exactly what I wanted.
I’ll let you know now…value averaging does perform slightly better than dollar cost averaging. But let me explain why.
What Is Dollar Cost Averaging?
“Dollar-cost averaging (DCA) is an investment strategy in which an investor divides up the total amount to be invested across periodic purchases of a target asset in an effort to reduce the impact of volatility on the overall purchase. The purchases occur regardless of the asset’s price and at regular intervals. In effect, this strategy removes much of the detailed work of attempting to time the market in order to make purchases of equities at the best prices. Dollar-cost averaging is also known as the constant dollar plan.”– Investopedia
In other words, dollar cost averaging is the most basic form of long term investing. Each month, you buy the same dollar amount of an investment but at different price points. Here’s an example:
In January, John uses $100 to buy 10 shares of a stock at $10 a piece.
In February, John uses $100 to buy 12.5 shares of the stock when it drops to $8 a piece.
In March, John uses $100 to buy 5.55 shares of the same stock at $18 a piece.
You can see that this stock price is pretty volatile. However, since John has been dollar cost averaging he has accumulated 28.05 shares for an average of $12/share.
Dollar cost averaging has 3 main benefits:
- Simple – Dollar cost averaging can be set up and left alone. It requires no additional action each time you buy.
- Stability – Even when prices are volatile, dollar cost averaging decreases volatility be averaging your price point.
- Low-Risk – Rather than making one poorly-timed lump sum investment, dollar cost averaging spreads your investment over a long period of time.
What is Value Averaging?
“One strategy that has started to gain favor is value averaging, which aims to invest more when the share price falls and less when the share price rises. Value averaging is conducted by calculating predetermined amounts for the total value of the investment in future periods, then by making an investment to match these amounts at each future period.”– Investopedia
In value averaging, you set your target growth for each period. In order to meet that target, you may need to invest more during some periods and less during others. Here’s an example from that Investopedia article:
As you can see, the person who uses dollar cost averaging invests $1,000 a month, regardless of the stock price. The person who uses value averaging needs their investment to grow by $1,000 a month, so they have to invest various amounts to reach that goal.
When the stock price rises, you don’t have to invest that much. But, when the price falls, you need to be prepared to invest a lot more.
Value averaging has 3 main benefits:
- Lower Average Cost – Because a lot more is invested when the market drops, the average cost is a lot lower than dollar cost averaging.
- Lower Total Cost – Less money is invested to generate the same results as dollar cost averaging.
- Higher Gain – Even though you invest less, you have a higher return as shown in the example above.
The Example Used For My Research
Warning…the rest of this post will be pretty sophisticated. You can thank my inner nerd for that. But, I’ll do my best to explain it and I’ll make sure to recap everything in the end.
I needed to find some stock market data that could be used for my research. Luckily, Google Sheet’s “=GoogleFinance” function is amazing and allowed me to find some data very quickly.
With the help of Google, I was able to pull up weekly data for SWPPX from 2011-2020. SWPPX is an index fund based on the S&P500 so it is a pretty good representation of the stock market as a whole. Unfortunately, I had to use weekly data instead of monthly data which isn’t what I wanted but will work. And while I thought I pulled ten years’ worth of data, it ended up being just over nine years because the 2020 data I grabbed ended at the start of the year.
In this example, I had the person invest $25 per week which works out to be an average of $108.33 per month. Once again, it’s not ideal but will work. The sample principles would still apply if the person invested bi-monthly, monthly, or quarterly.
In all of the strategies below, I tried to make the principle as close to $11,800 as possible. The premise of the research was that we couldn’t invest more than we originally allocated to investing which is $25 a week. We could save that $25/week for the perfect time to invest, but we couldn’t invest beyond what we had saved for investing. In other words, we couldn’t invest extra cash because we didn’t have that cash saved yet.
Alternative Investment Strategies
So after setting the parameters for what I wanted to test, I tried several different strategies which I will list below. By the way, I came up with most of the names for these strategies, they aren’t actual strategies you can research (besides dollar cost averaging and value averaging).
Strategy #1 – Dollar Cost Averaging
In order to have a baseline for what we are shooting for, I tested how dollar cost averaging would have faired over that nine year period.
Current Value: $19,875.56
Annualized Rate of Return: 11.60%
2011 – 2020 was a pretty good time for the stock market. In 2011 we were just coming out of the recession so prices were just starting to rise. The data that I had ended in January of 2020 which would have been right before COVID-19 shut down the economy. As a result, dollar cost averaging had an annualized rate of return of 11.60% which is very good. This is the baseline we will try to hit or exceed in other strategies.
Strategy #2 – Stop Cap
The first strategy that I tested isn’t featured here. In this strategy, whenever the market dropped, we would invest a proportionate amount into the market depending on how much it dropped. The problem with this was that sometimes the spreadsheet would invest more money than we had available which is against the rules of my research.
So, I set up a “stop cap” where we wouldn’t invest more than a certain amount when the market drops. This ensured that we wouldn’t use all of our money at a certain time.
Current Value: $19,756.84
Annualized Rate of Return: 11.48%
The best stop cap I come up with is a stop cap at 75% of the money you saved. So, even on the worst week in the markets, you could only invest 75% of the cash you had saved for investment purposes.
This doesn’t mean that you always invest 75%, but that is the maximum you can invest. If the market doesn’t drop a lot, you’ll invest less than that.
At this point, I couldn’t match our dollar cost averaging rate of 11.60% and I had a couple of theories why. The first of which was that we weren’t buying enough when the market dropped. The other theory was that our money wasn’t getting into the market soon enough which obviously is the upside of dollar cost averaging.
Strategy #3 – 75%
With that in mind, I wanted to give something a try. What if instead of the maximum limit being set at 75%, you always invested 75% of what you had. So even if the market dropped 0.001%, you would still invest 75% of whatever you had saved for investing.
On paper this should not work, but it actually performed slightly better than my stop cap strategy.
Current Value: $19,804.56
Annualized Rate of Return: 11.53%
Unfortunately, it still didn’t match the 11.60% that dollar cost averaging generated. At this point I was sort of lost for what to try next which is when I started to do some research. It was at this point I stumbled upon value averaging which was the exact strategy I was looking to create.
Strategy #4 – Value Averaging
One flaw in the Investopedia example I used above was that the target growth didn’t actually grow. In the example, the target value was always $1,000 more each quarter. The problem with this is that it doesn’t allow for any compound interest to take place.
Each quarter, the target growth should grow by 2.5% to keep up with the growth of the investments. Otherwise, eventually your investments will be growing faster than your target value which will result in you not investing any additional money.
With that in mind, I came up with a target growth value of $25 per week + 0.225% growth. So on week 1, my target value was $25.06 ($25 x 1 weeks + .225%). Week 2 my target value was $50.17 ($25 x 2 weeks + .225%) and so on.
Once I did that, here were the results:
Current Value: $20,818.75
Annualized Rate of Return: 12.60%
Finally! We beat the dollar cost averaging annualized rate of return of 11.60%! Not only did we beat it, but we were a whole percentage point ahead!
Despite me growing the target growth value, our investment still ended up growing faster than target growth rate. However, I couldn’t change the target growth rate because that would increase the amount of principle that would be required which was against the rules.
When this happens in value averaging, you are actually supposed to sell off your shares. That’s right, when you’re making too much money you have to sell off your shares to slow your growth.
It doesn’t seem right, does it?
Strategy #5 – Never Selling
So the next strategy I tried was one very similar to value averaging except, we would only buy and never sell. Every time our investment outperformed our target growth rate, we would just not buy instead of selling.
I thought for sure that this was going to be the best strategy yet, but I was wrong.
Current Value: $20,119.30
Annualized Rate of Return: 11.87%
11.87%! Surely that isn’t right! Turns out it is, and it makes sense when you think about it.
Remember that saying, “buy low sell high”? We’ve been focused on the buy low part, but not so much on the sell high part. The reason why value averaging works is because you can get value from the profits gained by selling high and buying back low.
Suppose you owned one share of a stock for $70. Your target growth rate is $10 per month, so this month you want your investment to be worth $80. This stock skyrockets to $100 so value averaging requires you to sell .2 shares for $20 to get back to $80. Congrats, you just profited $20.
However, next month the stock price goes down to $80 when your target value was at $90. This means that your .8 shares is only worth $64 now. You must spend $26 to get to $90. However, since you had a $20 profit earlier, you only need to add $6 to your overall principle.
You now own 1.125 shares worth $90. Your friend that used value averaging but never sold also owns 1.125 shares worth $90.
So what’s the difference? The difference is in the principle. Your principle is $76 while your friend’s principle is $80. It’s a small difference but enough to show why selling is actually good for value averaging and never selling doesn’t work as well.
Here’s a table showing that example:
|Price||Target Value||Principle||Shares||Value||Cash Profit||Principle||Shares||Value|
I know that might have been a little confusing, but basically, it comes down to selling high and using those profits to buy back in low. Doing this will lower your principle and give you a better rate of return.
But, something we didn’t consider was taxes. If you sold .2 shares in month 2, you would be obligated to pay taxes on the capital gains from that transaction. Assuming you kept the stock for over a year you would owe taxes on 15% of that $20 profit which would be $3. This means that your real cash profit would be $17 and your principle when you bought back in would end up being $79 which is slightly better than $80.
So taxes do affect how powerful value averaging is, but it is still slightly better than my never selling strategy. If you used value averaging in a tax advantaged account like a Roth IRA, you wouldn’t have to worry about taxes lowering some of your gains.
The Best Investment Strategy
Now that we have gone over the 5 different strategies I tested, let’s recap the annualized rates of return:
|Dollar Cost Averaging||11.60%|
As you can see here the best investment strategy is value averaging with an average rate of 12.60% from 2011-2020. There have been several studies that have concluded the same thing over different periods of time. While it’s not a huge difference in percentage points, it could be a difference of thousands of dollars compounded over your lifetime.
3 Problems with Value Averaging
- The problem with value averaging and the reason why dollar cost averaging is still more popular is because value averaging is a lot more work. Dollar cost averaging can be set up once and will run for the rest of your life. Value averaging requires you or some investment manager to make your investments for you every time you want to invest.
- Value averaging is often critiqued because if the market goes through a long period where it is underperforming, you’re going to have to overcompensate to meet your target growth value, which may cause you to run out of money.
- Another issue that I see is that although value averaging is very efficient for each dollar that is used, it’s not necessarily the most effective at using all of your dollars when the market is doing well.
The Perfect Investment Strategy
In reality, the best strategy is probably a combination of all of these. You want a strategy that consistently invests, yet has money available for good buying opportunities. You want a strategy that buys in the red, yet still takes advantage of the green. Finally, you want a strategy that can be easy to use, yet generate high returns.
Check out this post for how to get started investing today!
That’s it! Those are some alternatives to dollar cost averaging. For most people, dollar cost averaging will be the most simple method to use with pretty good results. But for the advanced investor, value averaging might be the best method to maximize the efficiency and return for each dollar invested. I hope you enjoyed this rather lengthy and complicated post. Please let me know if you have any questions, comments, or concerns in the comment section below. Otherwise, happy investing!
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