Spotlight on Investment Strategies:
Dollar Cost Average vs Value Average
Please note: the information presented on this page is intended for educational purposes only. It is not meant to be investment advice; for such guidance, you should discuss your specific situation with a financial professional.
As you consider purchasing cryptocurrency, it is likely coming as you start to invest, diversify your assets, or else because you’re passionate about its future potential. Either way, you are effectively developing further your investment strategy, which is the approach you use in placing your capital into assets.
It can be useful to learn more about the other approaches to investment that are out there, and understand which ones expert investors tend to leverage—as well as why they choose the strategies they do.
One aspect of investment strategy involves allocation methods, or the approach you use to choose how much money you invest.
Dollar Cost Averaging: The Warren Buffett Classic
The dollar cost averaging (DCA) method involves investing specific amounts of money at fixed times, such as once a month or following the deposit of a paycheck into a bank account.
Of course, you get to choose what you invest in. Many people choose to buy cryptocurrency, often within an IRA so that they can leverage the long-term tax benefits while also building their nest egg for retirement.
It may be hard to visualize what your return on investment could look like, but fortunately BitWage has assembled a dollar cost average calculator available to empower you to do so. Seeing how much you need to invest over a certain amount of time in order to see a specific return helps you make the most informed investment decisions.
Those investing using the DCA method must be onto something if even investor magnate Warren Buffett recommends this method… but what are the two main advantages of the dollar cost average method? They center around reducing the long-term exposure you may face to losses:
- Takes away the emotional side of investing – Instead of investing in a reactive way, DCA lets you build an automated investment “machine” of sorts that keeps investing regularly until you tell it to do otherwise.
- Diminishes the risky impact of timing – Effectively, DCA lets you “diversify” your investment timing so that you are less susceptible to the fluctuations that can result from investing at a particular timepoint. Although to some extent this reduces how much you will capitalize on good timing, it greatly reduces the impact of bad timing—which includes the way an economic downturn could otherwise wipe out your investments.
No investment strategy will be a blanket solution to mitigate all possible risk, nor will any strategy eliminate the need to be savvy with the investments you select.
Dollar cost averaging might not look as tempting as some other strategies when you consider the way its investments perform in particular situations. For example, in a market gradually growing over time, small investments over time are less likely to attain the same level of returns as a lump sum invested earlier in time.
Value Averaging: A Powerful Alternative To Consider
Instead of focusing on a target amount to invest the way DCA does, value averaging (VA) focuses on targeting a particular portfolio value during each period. The quantity invested depends on portfolio performance.
Value averaging effectively takes a different approach to removing the emotional side of investing, using a separate approach than DCA. Instead of panic selling or big buying, it helps investors make calculated decisions based on market performance—but using realistic target values.
Value averaging involves increased allocations during market decline and reduced allocations during market climbs, in a way that adjusts for market performance relative to investor expectations. The rate of investment growth in turn affects how quickly the investor buys or sells.
Former Harvard professor Michael Edleson was one of the pioneers of the formal VA approach, which he published in a 1988 article and then ultimately in his 1991 book, Value Averaging: The Safe and Easy Strategy for Higher Investment Returns.
Of course, value averaging does not come without criticisms, including that it requires a very hands-on approach by investors and that the same end results can be achieved with lower resource allocations.
Dollar Cost Averaging vs Value Averaging: Which is Better?
Dollar cost averaging results in a somewhat mechanical allocation method that ensures that you continue to invest over time, and that strips away the emotional reactivity that can drive investors to make rash investment decisions.
Value averaging, although an allocation method, starts to venture a bit into the investment strategy side of things because it does change somewhat according to market performance. Under the VA approach, more money is invested when the asset is performing at a lower price and vice versa.
One issue with VA is that investors may run out of money before the market turns around, meaning that they did not get to purchase investments at the lowest price—and that would therefore garner the greatest returns.
As mentioned earlier, DCA mitigates the risk that sudden price drops will have a radical negative impact on your investment portfolio. The tradeoff is that you may not get to maximize your returns on your investments by aligning them directly with market growth, and any money waiting to be invested may end up sitting, waiting—and not earning.
At the end of the day, the allocation method you choose should resolve a specific problem or ill-performing tendency that you have. Because so many investors worry about reacting emotionally and want to adopt a more mechanical approach that earns returns but removes reactivity, dollar cost averaging is frequently adopted.
Multi-Asset Class Diversified Portfolios
Some investor advisory groups resort to yet another allocation method. The multi-asset class diversification method is intended as a direct counter-response to dollar cost averaging.
This allocation method does bleed a bit into investment strategy as it involves adjusting the potential risk associated with a portfolio’s performance by methodically spreading out the types of assets that are acquired.
This seems like a fancy synonym for diversification, but proponents argue that it’s a different approach. Instead of pacing investments over time following dollar cost averaging, investors following this method hit the ground running with as diverse a portfolio as possible, starting with at least three different asset types.
The argument is that there is low correlation between any three different asset types, and so the odds that all three will tank are extremely low. Therefore, this method should be a relatively reliable one for mitigating portfolio risk.
What Other Mistakes Do Investors Tend to Make?
When examining the relative success of a particular allocation method or even investment strategy, there are some useful data points to keep an eye on that shed light on the effects an individual’s approach can have.
- Average annual return (AAR) – Traditionally used with mutual funds, the AAR is used to predict and analyze long-term performance potential. It can be used to help select assets for investment.
- Average volatility – Volatility calculations are beyond the scope of this article, but as you consider allocation methods and build your investment strategy, consider the relative volatility of your assets. A financial advisor can help you balance volatility across your portfolio so that you can be as well positioned as possible to reach your long-term investment goals.
So what mistakes do investors tend to make with their portfolios?
- Investors may become complacent about the risks associated with their portfolios. At times, it can feel like investors can become desensitized from risk and forget that massive declines and market downturns are possible. One reason is the hindsight evident in retrospective analyses of major market events. After 2008, when the subsequent 2009 bull market was driving economic rebounds, many investors felt like if they had only held on to their investments they would have earned major returns. As a result, they may be inclined to “buy and hold” during a falling market, which can trigger an entire cascade of faulty investment decisions that can cost—a lot. In fact, it is such investors that may benefit the most from allocation methods like dollar cost averaging.
- Under-saving. A risk that has been found to affect retirement investors is that, instead of diligently contributing to their retirement accounts, they try to simply ride periods of high returns under the belief that this will be enough to build their nest egg. The gamble associated with this approach can, unfortunately, leave individuals in the lurch once retirement age hits. Even if it’s not always the sexiest or “most lucky” option, slow and steady is an approach that reliably builds over time.
A frank, candid look at your approach and the mistakes you tend to make can help you pick the best allocation method to counterbalance the risks you might naturally gravitate towards, and this can be a critical first step to designing your custom investment strategy.
As always, be sure to consult with a financial professional regarding your particular situation and goals so that you can get the best possible advice.