Value Cost Averaging or Dollar Cost Averaging?
“When I’m bearish and I sell a stock, each sale must be at a lower level than the previous sale. When I am buying, the reverse is true. I must buy on a rising scale. I don’t buy long stocks on a scale down, I buy on a scale up.”
When investing, people often fear that they’re going to miss the great run up or miss the next great buying opportunity. We tend to overreact when we see a stock going up and think that we’re going to miss the next great Google, Apple, or Pets.com and rush to buy. On the other side, when stocks are sliding, we tend to panic and think that they can only go down. As a result, individual investors often buy high and sell low – the polar opposite of what they want to do.
A common way that people pose for avoiding this scenario is to invest the same amount periodically, called dollar cost averaging. So, let’s say that you want to invest $1,500 in a year. Instead of buying all at once, invest $125 per month. That will ensure that you buy more when the price is lower and less when the price is higher. In general, this is a better approach than the buy all at once approach. Naturally, if you buy at the lowest price in a year, you can do better, but how many of us are so skilled at market timing that we can do that?
What dollar cost averaging doesn’t accomplish is allow you to spend more when prices are lower and spend less (or even sell) when prices are higher. This approach is called value cost averaging. The approach to value cost averaging is to specify a given return on money invested and then buy or sell shares to get to that total value. So, let’s say that you want to invest $1,500 in a year and want an 8% return. The first year, you invest $1,500. The second year, that $1,500 should be worth $1,620, and you’ll add another $1,500. Therefore, you buy or sell enough shares to have a total of $3,120 worth of shares.
How does value cost averaging work compared to dollar cost averaging? Furthermore, how often should you do this?
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Jason Hull is a Fort Worth fee only, hourly financial planner who serves clients in Fort Worth, TX and Dallas, TX as well as serving clients nationwide.
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