Personal finance revolves around the constant balancing act between spending and savings. There are other tensions, of course, such as finding the best way to invest your money to achieve your long-term goals. Value averaging and dollar-cost averaging are two types of approaches that encourage regular contributions to your investment portfolio. So, how can you know which one is right for you?
Both value averaging and dollar-cost averaging are designed to encourage you to regularly invest in the market. However, each approach offers a slightly different take on the best way to gradually build up the value of your portfolio.
What Is Value Averaging?
Value averaging is the idea that you will vary your investments based on the value of your portfolio. To pursue this strategy, you will first decide on the value your portfolio needs to increase on a monthly or quarterly basis (or other time interval of your choosing) in order for you to meet your long-term investment goals.
You will then invest different amounts of money per chosen time period in order to keep pace with your desired rate of growth.
For instance, let us say that you wish to increase your portfolio by $500 every month. You choose a particular ETF to invest in, making an initial purchase of $500. After one month, your investment has grown by 10%, and it is now worth $550.
In your second month of investing, you will only purchase $450 worth of the same ETF. After two months, you will now have $1,000 worth of this ETF. This “averages” out to $500 per month, hence the name of this investment strategy.
Therefore, the amount you contribute to your investment is completely dependent on the market’s performance. You will purchase more assets when the value of your portfolio decreases, and you will purchase less when it increases.
What Is Dollar-Cost Averaging?
Dollar-cost averaging, on the other hand, does not depend on how the market or your investment is doing. You will make the same contribution into the same asset every single time period, regardless of whether or not the market is a bull, a bear, or somewhere in the murky middle.
Working off of the previous example, using dollar-cost averaging, you will invest $500 into the ETF of your choosing every single month. When the value of the asset rises, your $500 will be able to purchase less of the security. When the value of the asset declines, your $500 will go further. The cost at which you are purchasing the asset should balance out.
In other words, you will average out the price at which you are purchasing the asset in question. This approach is often considered a safe and secure one, as you will avoid the risk of putting your money into the market at inopportune times.
What Is the Difference Between Value Averaging and Dollar-Cost Averaging?
Both value averaging and dollar-cost averaging create a framework for regularly investing in the market. With value averaging, your investments depend on the market’s performance; with dollar-cost averaging, they do not.
Value averaging offers a couple of advantages over dollar-cost averaging:
(1) Buying low: When the value of the asset you are purchasing decreases, you will purchase more of it to make up for this shortfall in your monthly contributions. This will allow you to buy low by definition, putting more money into the market during downturns (which, if the past is prologue, will eventually go back up).
(2) Maximizing value: It follows that this strategy allows you to maximize the value of your investments. Dollar-cost averaging, by definition, will not allow you to do this.
On the other hand, dollar-cost averaging has a few pronounced benefits as well:
(1) Easier to manage: Dollar-cost averaging is simple to adhere to. You determine the asset, amount, and interval at which you wish to invest. Once this decision has been made, your investments will be straightforward. Depending on the asset and your means of investment, this can also be automated.
(2) Less risky: Because you will be investing the same amount of money during every chosen time period, you will remove the risk of bad timing. Sometimes you will buy low, while sometimes you will buy high. Eventually, these purchase prices will average out, and your investments will increase as the market moves upward (as it has done throughout history).
Which Should You Choose?
Both value averaging and dollar-cost averaging can serve long-term investors who wish to steadily grow their portfolios. The decision comes down to two main factors: (1) how much you wish to be involved in the monitoring and management of your portfolio and (2) your comfort level with risk.
Those who are willing to follow their investments more actively and who are able to absorb certain months when more cash is needed, could consider value averaging a potentially good strategy.
For those who are less inclined to follow the market’s ups and downs and wish to avoid the risk of price volatility, dollar-cost averaging can be a good option. Using TipRanks’ dollar-cost averaging calculator, you can experiment with different amounts, time intervals, and assets to understand how these various components will allow you to build your wealth over time.
Conclusion: Investing for the Long-Term
One of the keys to investment success–both for professional money managers and those without any financial training–is holding on to assets for the long term.
By promoting regular investments at predetermined timeframes, both value averaging and dollar-cost averaging are built to encourage a long-term outlook.
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