Friday, 19 May 2017

A new way to invest: Dollar Value Averaging

Investing seems like a big scary monster when you haven't done it before. The idea of throwing in your hard earned cash and then crossing your fingers and toes that the next market crash isn't around the corner is enough to give anyone goosebumps. But there are a few tried and true methods to mitigate some of that risk.

I've just learned about a variant on an old favourite, Dollar Value Averaging is here to challenge Dollar Cost Averaging for the easiest way to plan your investment buying.

Before we start I need to clarify that this post is talking about investing in Exchange Trade Funds (ETFs) on Index Funds that track big financial things like the Standards and Poor's (US) and the All Ordinaries (Australia). I am not talking about individual stock picking, which is a whole other kettle of fish.

The biggest fear most people have with investing is that their investments will tank and they will lose money. This is a perfectly rational fear and it's part of the reason why I love RateSetter and Acorns because they allow you to invest small amounts of money. That way you can stick a toe in the water, feel around and decide whether you're in for a pleasant swim or an unpleasant ice-bath.

Sometimes (like now) the sharemarkets run upwards in a seemingly endless climb. Other times, like the dot.com crash of 2000, the Global Financial Crisis in 2007 and the day of Donald Trumps election the markets crash so hard it looks like winning is impossible.

Timing vs. Time In

A brilliant post by Ben Carlson shows that even if you invest the day before these horrendous crashes, you'll still end up ahead as long as you don't panic and sell. Throwing money in and leaving it there is up there with your safest investing choices.

By using either Dollar Cost Averaging, or Dollar Value Averaging you can confidently commit small amounts of money to the share market at regular intervals. In both cases you'll be buying when the market is high, and when it's low in the hopes of balancing it out over the long-haul.

Many people try and time the market by watching to see what is about to go up and what is about to go down. They try and buy right before the booms, and sell right before the busts. If you can pull this off, that is amazing. There are billion dollar investment companies that can't do that. And if you do it wrong you'll end up selling in the middle of the GFC because you panicked, or seeing a market rally and buying in when the price has already peaked.

However, if you get in and stay in, you can ride these peaks and troughs. The S&P has more than tripled since the dot com crash in the early 2000's, but you can only cash in on this massive return if you are in the market.

So if you aren't a mastermind and can't time the market, how do you know when to buy in? The answer is all the time.

Dollar Cost Averaging

Dollar Cost Averaging (or DCA to save my typing fingers) is the favorite of set and forget investors everywhere. Anywhere that you can make a direct deposit into your investment account is a perfect setting for DCA.

The concept is super simple. Decide how much you want to invest each day / week / month, then set up a direct payment from your bank account to your investment. I have these set up for Vanguard, RateSetter and Acorns

Without any effort or having to remember I invest $550 a month. It's great because I don't need to monitor the markets or second guess if now is a 'good time' to invest. It all happens quietly in the background.

Except being the spreadsheet fanatic I am I track it religiously. But I could ignore it and it would work just as well. I just like watching the numbers tick up :)

Dollar Value Averaging

I'm a huge fan of dollar cost averaging because it's such a set and forget option, so when someone mentioned Dollar Value Averaging I just assumed it was a different name for the same thing. Not so, it's a similar but different concept that edges out a tiiiiny bit better performance - as long as the value of your investment is going up.

When we Dollar Cost Average we put in the same amount each time, regardless of the price of our investment. So when the shares are $1 each we spend $1000 on 1000 shares. When they're $1.10 we still spent the same amount, but we get less shares.

Dollar Value Averaging doesn't focus on the amount you put in, but the value you want to hold. With DCA we put in $1000 a month, and let the value of the portfolio fluctuate any which-way (hopefully up!). With Dollar Value Averaging we declare that we want our portfolio to be worth $1000 more each month. So if the price of shares drops, our portfolio value drops and we have to put in more money. If the value goes up, we put in less.

Confusing? Look at it this chart, charts always help

In both cases we've decided to increase our investment by $1,000 a month. With DCA we throw $1,000 a month at it and get a rather nice 3.84% return in six month. (These are real numbers by the way, it's the last six months of Vanguard's Australian Share Market ETF). 

However, with DVA we only spent $5,772.87 and got a slightly higher return at 3.93% (over a year that'd be a whopping 7.83%!)

What happens if the prices go down? Well with Dollar Value Averaging you spend more, but your Return on Investment (or in this case, loss on investment) is slightly less bad.


Do we have a winner?

If you're willing to put the extra effort in for the slightly higher return, dollar value averaging wins out. Just. But there are practical issues like having the spare money to invest when the market tanks and your plan calls for throwing in a bigger contribution. There are also the psychological risks of seeing it fall and thinking 'maybe we'll skip this month, in case it falls further'. It might be a wise move, you might miss buying shares on sale.

On the other hand, if the markets are running up and up, you might end up not investing as much as you planned and having money left over. Anything sitting in your account waiting to be deployed is earning less than it could be on the markets.

If you're disciplined enough to stick to the plan, Dollar Value Averaging can give you a slight edge. In the above scenario the difference in return will put you ahead $1,850 after ten years. That's not a small amount, but it also might not be worth the extra effort that Dollar Value Averaging requires.

Choose your own adventure. Would you rather work harder for the extra 1.8% annual return? Or take the effort and emotion out of the process and let your investments run on autopilot? 


4 comments:

  1. Currently I am of the opinion that I prefer to set and forget. I reckon if I have to keep an eye on it everyday, monitor it religiously, it will become too much like a chore and I will get way too emotionally involved and make bad decisions. Having said that, things do change - we will see what the future holds!

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    1. I agree - set and forget investing is what has gotten me this far. I only monitor it because it's fun for me, and because it helps me see where I can improve those set and forgets - i.e. can I turn my regularly $100 investment into $150?

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  2. This is interesting! I also thought it was the same as dollar cost averaging. But I also agree it might be a bit tedious to achieve, especially if there are inefficiencies in the process. For example in my country, it takes a day or two before my investment is settled and by then the prices might have already changed. :\

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    1. All my investments take a couple of days to process as well. I don't worry too much about it though because (unless we're looking at Election day in the States) most of the time the swing in prices during a day or two isn't too crazy. If you need perfect round numbers it'll be frustrating, but the swing shouldn't throw the strategy out entirely.

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