|
Setting Up an Ongoing Investing Program
Step 3: Which Averaging System Will Work Best for Me?
Under the value averaging approach, the ending total value will be the periodical value increase times the number of periods—in this example, $1,000 times 23 quarters, for a total ending value of $23,000. In other words, when you start the value averaging program, the ending amount is known, but the amount to be invested isn't.
Under the dollar cost averaging approach, the total value at the end of the period could be any value, but the total amount invested is equal to the number of periods times the periodic sum—in this example, 23 quarters times $1,000, for a total amount invested of $23,000. When you start the dollar cost averaging program, the amount to be invested is known, but the ending amount isn't.
Keep in mind that the goal of value averaging is to increase the portfolio by a fixed amount each period, and it may take substantial total amounts invested to do so, conceivably much more or much less in total than the certain dollar cost averaging sum.
Which approach works best? While either approach could dominate over any time period, value averaging probably has the edge because it is more aggressive. However, value averaging
- requires more monitoring
- more transactions costs, and
- because it triggers sales, potentially more tax consequences.
Value averaging can be modified so that no sales take place, with future value increases adjusted to compensate. Also, the loss potential is greater for value averaging because the total amount that is required to be invested is unconstrained.
Please note that you cannot judge which approach did best in the examples simply by looking at ending portfolio values because the amounts invested and the timing of the investments differ for the two approaches. The calculation to determine performance is called an internal rate of return calculation that takes into consideration all the cash flows and their timing. These returns are given at the bottom of each example.
|
