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Setting Up an Ongoing Investing Program
Step 2: How Do I Implement a Periodic Investing Program?
Table 1 and Table 2 show examples of dollar cost averaging and its more market-tuned cousin, value averaging, illustrating the structure of each investment plan and highlighting the differences. The investments in the example are a broad-based stock index fund, and an aggressive growth mutual fund; the time period covered is five and a half years; the investment frequency is quarterly. These two averaging approaches could be used to invest in individual stocks as well.
Dividend and capital gains distributions are ignored to simplify the presentation, but for investors, the reinvestment of all dividends and distributions should be part of any investment plan.
The examples use a $1,000 quarterly contribution for the dollar cost averaging approach: $1,000 is invested each quarter at whatever the prevailing price of the security is at that time.
For the value averaging approach, a $1,000 quarterly increase in value is used: The amount invested quarterly varies such that the total value of the investment increases by $1,000 each quarter; if the share price rises enough to cause the investment to increase by more than $1,000 during the quarter, shares would be sold to hold the increase in value to $1,000 for the period. For example, in the first quarter of Year 3, Aggressive Growth Fund jumped from a net asset value of $7.06 to $8.34 (Table 2). To keep the increase in value to $1,000, the following calculations must be made: At the end of the quarter, the investor held 1,274.79 shares with a net asset value of $8.34 before any changes, so the value of the portfolio would have been $10,632 (1,274.79 x $8.34, rounded), an increase of $1,632, or $632 more than the planned $1,000 increase. That means that 75.75 shares ($631.73 divided by $8.34, rounded) would have to be sold.
While dollar cost averaging is unchanging, value averaging forces sales when prices rise sharply and forces larger purchases—more shares purchased—when prices fall. For example, in the fourth quarter of Year 4 the share price of Aggressive Growth Fund fell to $7.94 from $9.47 the previous quarter. That resulted in a $3,423 investment under the value averaging approach. Although there was a much bigger price drop the first quarter of Year 2, few shares were held at that time, so the increased investment required was less, at $3,079. With a volatile market or a volatile investment, or both, as was the case with Aggressive Growth Fund in Year 4, the $3,423 additional required investment was followed two quarters later, after a price run-up, by a redemption (a sale of shares) of $5,928. The experience for Broad-Based Stock Index Fund (Table 1) is similar, but because the index fund is less volatile than the aggressive growth fund and had a lower return for the period, the investments and redemptions are of a smaller magnitude under the value averaging approach.
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