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Recently, I received a comment on the post, Valuation-Informed Indexing vs. Passive Investing - Which Is Better?, asking whether I had used dollar cost averaging or dollar value averaging in my analysis.
In that case, the answer was "neither" because the analysis merely looked at the performance/growth of a $10,000 initial investment using both Valuation-Informed Indexing and passive investing in an attempt to determine which strategy was more effective.
However, the question definitely got me thinking about my own personal finances, whether dollar cost or dollar value averaging is better, and which I should recommend that people utilize.
To begin addressing these questions, we first need to have an understanding of what each method involves.
Dollar Cost AveragingIn Dollar Cost Averaging, the idea is that a constant amount of money is invested each month in to your account. Therefore, you will naturally buy MORE shares when the market is down and LESS shares when the market is up. Sounds like a good, simple method, right?
Dollar Value AveragingIn Dollar Value Averaging, the idea is to meet portfolio value goals that you pre-define at regular intervals throughout the year.
For example, say you bought the S&P 500 index mutual fund with Vanguard in your Roth IRA for $3000 in 2010. In 2011, you plan to contribute $200 per month to the fund for all 12 months. Therefore, you would then lay out value targets throughout the year as follows.
End of Month Portfolio Values
At the end of the month, you assess the current value of the portfolio and compare it to the targets above. For example, if at the end of January, the fund is worth $2900, you would then contribute $300 instead of $200 in order to force yourself to buy more shares when the market goes down. Then, at the end of Feb, the market has gone up a lot and we find that the value of fund is currently $3500. Since it is over our target, we would then invest nothing in the stock fund, and instead place the investment money in a cash or fixed income security. Make sense?
Why Do Most People Use Dollar Cost Averaging?
In my reading over the years, most experts seem to agree that dollar value averaging is more effective in the long term than dollar cost averaging.
However, dollar cost averaging seems to be more aligned with how most investors save money/contribute money to their retirement plans. It is also a simpler approach/strategy to roll out.
So, why do most people use dollar cost averaging, despite the consensus among experts about the superiority of dollar value averaging? Well, the majority of investors (me included) invest money for retirement in one of three ways, as described below.
- They specify to contribute a set percentage (dollar cost) of their monthly income to their 401k retirement account.
- They specify a percentage (dollar cost) of their monthly income to contribute to their Roth or Traditional IRA.
- They spend money throughout the month according to their routine. Then, at the end of the month, they invest the money they have left over in their Roth or Traditional IRA.
With dollar cost averaging, the investor simply takes the money specified above as it becomes available and invests it for retirement according to their asset allocation targets.
Potential Problems with Dollar Value Averaging
On the other hand, if dollar value averaging is used, there are several complications that can result. First, if the market has increased significantly, the money may have to be "parked" in a money market mutual fund/cash account until it can be invested. As we'll discuss below in my analysis, this could be for a period of longer than one year, and you don't want to miss contributing to an IRA for a whole year. Therefore, certain accommodations will need to be made for this.
Second, if multiple mutual funds are employed in your asset allocation (both fixed income and equity asset classes), dollar cost averaging would force you to naturally contribute more money to fixed income securities when the market is overvalued. Therefore, is it really necessary to follow dollar value averaging in this case?
My hypothesis/initial answer to these complications is that the advantages of dollar value averaging are significant with a one mutual fund, equity-only portfolio, but that the advantages diminish as one moves to a portfolio that incorporates fixed income securities.
However, due to the importance the decision of using dollar cost vs. dollar value averaging can potentially have on long-term returns, I wanted to perform a fairly in-depth analysis to determine what trends result.
Analysis - Dollar Cost Averaging vs. Dollar Value Averaging - Which Is Better?In order to determine whether dollar cost or dollar value averaging demonstrated out-performance over a long-term period, I examined the portfolio value growth of two hypothetical portfolios over the past 10 years (June, 2001 to June, 2011) employing dollar cost and dollar value averaging.
Both portfolios assume a monthly target contribution of $500. The only difference is that for the dollar cost averaging strategy, this is the exact amount invested on a monthly basis, while for dollar value averaging, we will be targeting to increase the portfolio's value by $500 each month.
Portfolio 1 - Assumes that the portfolio is made up of a single equity mutual fund. In the analysis, I used the Vanguard Total Stock Market Index Fund.
Portfolio 2 - Assumes that the portfolio is made up of the same equity and fixed income index mutual fund mix that I currently employ (see table below for detailed allocation splits). Overall, this portfolio has 25% of the assets in fixed income securities, 75% in equities, and employs monthly rebalancing.
The complete results of my analysis can be found at the Google Docs Spreadsheet link below.
Google Docs Spreadsheet - Dollar Cost vs. Dollar Value Averaging - Which is Better?
A summary of my findings can be seen in the table below. To my surprise, dollar value averaging resulted in a 13% out-performance (return on investment) of dollar cost averaging over the 10 year period. A pretty significant find!
Another thing that was very interesting to discover was that in Portfolio 2, not only does using dollar value averaging decrease the risk/standard deviation of portfolio value, but it also results in me investing almost $13,000 less in the market and ending up with almost the same amount of money! Talk about "a free lunch!"
Because of 1) the results found in my analysis and 2) the previous books I have read agreeing that dollar value averaging is the "way to go," I think it's time that I begin thinking about implementing this strategy to new money I invest in my finances.
However, to do this, it will not be 100% easy. Therefore, I will need a solid plan to ensure that the implementation goes successfully!
Implementation Plan for Changing from Dollar Cost to Dollar Value AveragingIf you look at the pink highlighted Column P of the "Multiple MF Portfolio" tab on the shared spreadsheet, you'll see what I mean when I said that dollar value averaging is not the easiest thing to do!
Why is this you might be asking? It stems from the fact that with dollar value averaging, the amount you need to invest VARIES greatly in order to keep your portfolio value steadily increasing.
For example, in February 2009, dollar value averaging dictates that I needed to invest $4,833 that month. However, from March, 2009 to present, the system dictates investing $0. While investing $4,833 in one month sounds like a wildly large amount of money, overall, dollar value averaging only causes you to invest more accumulated money than dollar cost averaging 26% of the time (so, not that often).
Even though dollar value averaging recommended keeping money out of the fixed income and/or equity market from March 2009 to the present, I definitely would not want to miss out on contributing money each year to my tax-privileged 401k or Roth IRA accounts.
Because of this concern and the fact that I have already contributed the maximum allowed to my Roth IRA for 2011 (so I am too late to do it this year), the way I plan to implement dollar value averaging in 2012 is shown below:
- Using the spreadsheet above as a template, I will create a spreadsheet with the goal of increasing my overall portfolio (excluding condo ownership) by $420 each month.
- The $420 per month increase is calculated by dividing the maximum allowable 2012 Roth IRA contribution of $5000 by 12.
- On the 1st or 2nd of each month, I will automatically transfer $420 to my Roth IRA Vanguard account and direct it to be invested in the Vanguard money market mutual fund. We'll call this my "money parking lot."
- Also, at this time, I will examine my current portfolio's asset allocation percentages and determine if I need to move around any money within the tax-deferred accounts (but will not touch money in the "parking lot."
- On the last day of each month, I will compare my total portfolio value to the target value (old value + $420).
- If the current value is less than the target, I'll take the money that is in my "money parking lot" and invest it in such a way that maintains my asset allocation targets.
- If the current value is more than the target, I won't touch the money in the parking lot.
- It will be important for me to include the parking lot cash/funds in my overall net worth calculations, but to exclude them when looking at my portfolio asset allocation percentages. This is due to the fact that the added cash could skew the "invested" asset allocation levels.
- This process will then be repeated each month.
Implementing dollar value averaging to a 401k would be similar. You would set up your set % contribution of your income each month to your 401k. Then, you would "park" this money temporarily in a money market mutual fund within the 401k until your dollar value averaging calculations dictated moving it in to your asset allocation mix.
For quite some time now, I have read about the benefits of using dollar value averaging. However, for one reason or another, I always talked myself out of implementing the strategy for my investments.
But, after seeing the 13% out-performance of dollar value averaging over dollar cost averaging over the past 10 years in this analysis, I am now convinced enough to try it. I am hopeful that it will be an effective strategy, and also one that becomes easier to execute each month as I become accustomed to doing it. Wish me luck!
How about you all? Do you currently use dollar cost or dollar value averaging for your investing? Which do you think is superior/provides superior returns?
Share your experiences by commenting below!