Investing — Strategy — 401(k)
The DCA is often an easy way to start investing in stocks, cryptos or ETF. But find out why value averaging could be more useful to reach your financial goals.
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Key Points
- Dollar Cost Averaging (DCA) and Value Averaging (VA) are two investment strategies.
- Value Averaging provides better returns without additional risk.
- However, it requires a bit of involvement, more like being on a semi-automatic pilot than DCA (fully automatic).
Why Considering Investment Strategies
Equity markets still offer strong returns to investors, but risk management is key over the long term. However, investors often tend to forget that one of the major sources of risk on the stock market is found… In them.
We are all human. And according to behavioral finance, the greed and fear of investors would form irrational behavior and affect their portfolio allocation. The good news is that you can easily overcome these weaknesses in your mind and volatility in general by following an investment strategy.
Put simply, an investment strategy is a predetermined plan that will mechanically guide you through the investment process, putting emotions aside. You might already know one of them, the Dollar Cost Averaging (DCA). DCA is probably the most widely investment strategy used in the world.
DCA has the advantage of perfectly mixing lazy investing, global ETF investment plan systems and automated and regular investing. The perfect example is its use in 401 (k) plans.
All these tools allow you to invest without any emotional influence, which significantly reduces the risk of bad timing. By applying DCA, you will invest a fixed sum of money in order to smooth out the ups and downs of the market… And that’s it.
Remember: in a DCA approach, you always invest the same amount, and you just buy. It’s important to keep that in mind for what follows 🙂
Value Averaging is another investment strategy, developed by Michael Edleson in his book “Value Averaging.” It shares similarities with the DCA, but remains despite everything very different by the amount invested and the investment approach. And you will see that it makes all the difference!
According to this strategy, an investor determines a target growth rate for the portfolio and adjusts the contributions to achieve this growth rate, according to specific objectives and the portfolio performance.
In other words: rather than investing a fixed amount each month, you invest according to your proximity to your objective at a given moment.
The Value Path, a Key Concept in Value Averaging
In a value averaging approach, you must first determine the value path they should follow, depending on the objective they are trying to achieve. This means that you should have a periodic objective (monthly, quarterly, etc.) on the destination of your investment. Here, let’s focus on a monthly period.
For example, you would define a value path by deciding that you want to increase the value of your portfolio by 5% or $1,000 per month. This would be regardless of what markets are doing (whether bullish or bearish). So you set a target amount or performance, then you adjust next month’s contribution based on the relative gain or loss based on the assets you own.
Inevitably, you will invest less when the value of the portfolio increases and more when it decreases. This is a key concept: you have defined where you want to go (this is your value goal), and the value path that will take you there. But this path will fluctuate considering the current value of your portfolio, compared to your overall goal.
A Concrete Example of Value Averaging Strategy
Are you lost? Let’s take an example:
- Say you set a goal to increase the value of your portfolio by $1,000 over a 10-month period.
- From this value, you deduct your monthly contributions. Let’s say you want to invest $100 per month (10 months x $100 = $1,000, which is your goal). So you invest $100 the first month.
- At the end of the first month, the prices have appreciated and your $100 now worth $115. Therefore, in the second month, you only have to add $85 to reach your goal of $200.
- Over the next month, the markets go down and the value of your portfolio drops to $170. Here, you will need to invest $130 instead of $100 in order to reach your monthly goal of $300.
- And so on until you reach your final goal of $1,000 in 10 months.
You understand the logic behind: the amount to invest in month X is based on the performance of the portfolio in month X-1, because you react to the real evolution of the market. It’s a kind of DCA coupled with portfolio rebalancing.
The amount invested therefore changes every month, allowing not only to buy, but also to sell. For example, if in the example above, your goal for the fourth month was $400 and your portfolio value reached $450 at the start of that month, you would need to sell $50 in order to reach the goal of $400 for that particular month.
In both strategies (DCA and VA), the investor is disciplined and buys stocks in periods of market growth as well as in periods of downtrend. Thus, the risk of bad timing is eliminated, as is the impact of the investor’s subjective and emotional response.
But the two differences (variation of the amount and opportunity of selling) make it possible to take advantage of market trends even more while further eliminating its volatility. In the DCA approach, an investor does not look at the price level, but simply continues to invest in the purchase, over and over again.
We can therefore assume that the VA generates better returns compared to those of the DCA. Let’s take a look at some studies to check that!
The first study dates from 2000 and was conducted by Paul Marshal, a professor of finance at Widener University. He set out to compare DCA, VA, and random picking to determine whether one or the other technique offers a higher return on investment.
His results indicate that value averaging provides superior returns when prices are quite volatile and over long investment horizons. Best of all, these higher returns come with little to no increased risk. The study even seems to show that there is no statistical difference between DCA and random investment techniques, either in terms of expected return or risk mitigation.
If you are familiar with the Sharpe Ratio, you have therefore guessed that a VA portfolio will provide better Sharpe Ratio, since it offers better returns for equal or less volatility. That is precisely the conclusion of a second study of 2020, conducted by Haiwei Chen (associate professor of finance at the University of Alaska Fairbanks) and James Estes (full professor of finance at California State University, San Bernardino).
Note, however, that the probability of reaching the target value of a portfolio in VA is higher over a long investment horizon, of the order of 5 or 10 years. This third study conducted by the Department of Finance of the Faculty of Commerce and Economics of Mendel University shows a substantial increase in the Sharpe ratio over a long horizon of 10 years.
It makes sense! Indeed, if we consider a very short investment period (one year in the study), there is no room for stock price fluctuations and the trend is mainly up or down. Thus, it is just as possible to make high profits or high losses.
This is why there is significant income volatility over the one-year investment horizon (12.96%), which has not been compensated by additional returns (15.62%), i.e. a ratio of Sharpe of 1,201. On the contrary, there is a more stable evolution of returns and risks for long-term investment (average annual return of 7.53%, average annual risk of 4.51% and Sharpe ratio of 1,658).
These results are also in line with what Edleson writes in his book about Value Averaging: the longer the investment period, the lower the profit, but also the volatility. And therefore the risk/return ratio is higher (better) in the long-term investment period (in his case, a 20-year investment period).
The VA approach clearly has the added strength of being flexible and versatile. It will indeed ask the investor to buy more when the price is low and to sell when the price is high. DCA, on the other hand, completely disregards this information and simply invests a fixed amount, regardless of the stock price.
However, nothing is perfect. Here are some disadvantages of value averaging, as well as some precautions and considerations to be aware of:
- As explained above, although VA performs better than DCA, the benefits are really accentuated in a more volatile market.
- It is a more sophisticated system to implement. Where DCA is very simple to perform, calculating the value path is not always straightforward and assumes that you know in advance 1) the desired end value of your portfolio and 2) the effects of inflation to determine the desired growth rate and finally plot a realistic value trajectory. This second point is more complicated!
- Value averaging assumes that you have cash in reserve lying around. Because if the markets fall, you will have to increase the amount of your periodic investment. Without cash, that’s impossible: if you suddenly have to go from investing $500 to $1,000 to close a gap, you might struggle to keep pace with your value path. Except that having cash means not being fully invested, leading to suboptimal returns. Dilemma…
DCA and VA are two excellent investment strategies for establishing strong financial discipline. There is nothing better in the stock market than to take a mechanical approach to investing instead of being misled by your emotions, driven primarily by greed and fear. These strategies are relatively simple to implement, especially for those who carry out lazy investing in ETFs.
DCA can be easier to apply if you don’t necessarily want to adjust your investments every month and really be on automatic pilot. However, this investment strategy will unfortunately (in most cases) fail to allow you to reach your savings goal.
On the contrary, value averaging can be a very interesting option to better achieve this objective. By defining your personal value path, you can first determine how much money you will need to accumulate for a specific goal, month after month, while accompanying market variations more efficiently.
I’m Raphaël, founder and editor-in-chief of Investiforum.fr, a financial website for French-speaking private investors. Thanks for reading! Don’t hesitate to follow me on Medium, Twitter or Polywork.
This article is for educational and entertainment purposes only and shouldn’t be considered as financial or legal advice. Not all information will be accurate, but all the data is sourced. Consult a professional before making any significant financial decisions. This article shouldn’t be seen as an incentive to buy or sell any of the securities mentioned therein, nor endorsem*nt to any presented strategy.
