Both dollar cost averaging (DCA) and value averaging are two popular investing strategies to profit from long-term performance of stocks or similar financial instruments. Both are good ways of systematically building an investment portfolio by adding capital to existing portfolio monthly (or try-monthly or annually).
Dollar cost averaging, also known as Pound Cost Averaging and Constant Dollar Plan, is a simple systematic investment method, in which the investor continuously buys stocks, or mutual fund units or other instruments, of a fixed amount. Thus the portfolio investment is increased with a certain amount every month and the trader profits, buy selling off the instruments he holding at a desired time.
The basic idea of Dollar cost averaging is to profit from long-term performances of stocks and markets (around 11% per year for US markets) irrespective of short-term market ups and downs. DCA investors easily overcome market up and downs. When markets are down, investors can buy more number of stocks/units for a certain amount and when markets are up they can buy lesser number of stocks/unit for the same amount.
Value averaging is a more evolved investing strategy with an added value factor. Investors following value average buy stocks each month to attain a targeted portfolio value. For example if the target portfolio growth rate is $500 per month and the investor buys stocks of value $500 for the first month. In the second month if the original value has increased from $500 to $600, he invests less ($400) for current month to achieve the portfolio value target of $1000 for the second month. Likely if the portfolio value has dropped from $1000 to $900 in third month, he invests more ($600) to achieve the portfolio value of $1,500 for third month.
Advantages of Dollar cost averaging are it is independent of market timings other than the selling time steady growth of portfolio, minimum need of trading/investing experience and education, and best for persons with steady monthly income. But this strategy does not ensure good profits.
Advantages of value averaging are generally better profits than DCA, active management of portfolio investments, best for persons with investing experiences, good when investors want to take short-term profits.But the strategy may become difficult to follow in long-term. For example the above mentioned portfolio value target after 2 years will be $12,000. But because of a bullish trend it can decrease to $8,000; then one must need to invest $4500 ($12,000 – $8000 + $500 of monthly target) for the next month. Similarly there may be months in which no investments are needed.
