I'm sure many of us are familiar with dollar cost averaging. It's the idea of putting a consistent amount of money over a certain fixed interval into your portfolio regardless of the market movements. The whole idea is to be constantly invested in the market and keep your emotions at bay. Everything moves like clockwork.
Before I proceed further, please do not be mistaken that DCA is actually the best way of investing. It depends on the circumstances. If you have a lump sum to invest, the best way is to still invest your lump sum right now. If your DCA interval stretches beyond 12 months, statistics have shown that you have a higher chance of having lesser returns as compared to lump sum investing. I wrote about this last year, and you might like to check it out here.
However, real-life situations are usually a bit more complicated in the sense that you don't always have a lump sum to invest. A portfolio is always in the building phase when you are young, and you constantly have new funds coming in through your work or other means. Hence, DCA usually remains to be a viable option for most of us here to be investing our funds.
Besides DCA, there is another way of investing- that is called Value Averaging (VA). This is a less common term and some of you have probably not heard of it before. Generally, Value Averaging is another way of investing where you set a target growth rate for your portfolio and put in an amount of money relative to the gain of the portfolio over a certain fixed interval. For example, you have a portfolio of $20,000. You target a growth rate of 1% every month- this results in a growth amount of $200 in the next month. If your portfolio has a gain of $120, you will only put in $80 to make up the sum of $200 which is the target growth rate of 1%. If the portfolio ends up making a loss of $50, you will need to put in $250 to make up the 1% growth rate.
In a lot of articles and research, it has been found that VA actually results in a higher rate of return as compared to DCA. The reason is due to the fact that you actually invest more than you would have if you were to do DCA when the market is down and hence you will usually reap in more benefits when the market recovers. You may like to check out this article here.
Wait, if that is the case, why do you prefer DCA to VA?
Hold your horses, this is why.
While the rate of return tends to be higher when you do VA, the terminal wealth accumulated is usually lesser when you use VA instead of DCA. If the market has been constantly doing well, you will be putting in less money than you would have if you were to do DCA. This results in you not losing out time invested in the market and ends up holding too much cash instead. When extrapolated to a long period of time, the terminal wealth you accumulate will be lesser. And that's not the only downside to it. If the market has been doing bad for a longer than expected time, your cash will also runs out much faster than you are expecting. Once you have reached your maximum cash allocation, you could then no longer follow the VA strategy anymore. While nice in principle, the execution of VA is rarely as easy as it is in real life. If you like to explore further, check out this research paper.
Hence, I prefer to do DCA as having a higher terminal wealth accumulated is probably more important to me than just simply having a high rate of return. What I will do is to continually DCA into my portfolio. Through DCA, I will rebalance my portfolio to ensure that I'm achieving the ideal risk to reward ratio (essentially Sharpe ratio) I want in my journey to build a retirement sum. If you are interested to know how I am building this portfolio, join as a patron.
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