Dollar-cost averaging is as close to infallible investing as you can get, says Roy Miller, in David Chilton’s The Wealthy Barber. It can make downward fluctuations work for you by picking up more units when prices are lower, he adds.
But dollar-cost averaging which involves investing small amounts at regular intervals — may not be all that infallible. True, the logic initially looks compelling. Consider Mr. Miller’s example of investing $100 (into a mutual fund) in three periods at prices of $10, $5, and $7.5.
The number of units bought is 10, 20, and 13.3. Multiply the total number of units (43.3) by $7.50 to get the current value, $324.75. Thats nearly $25 more than the $300 put in, even though prices are down.
What’s missing from this analysis is whether one has a lump sum or a regular (e.g. monthly) amount to invest. If you have a lump sum say a maturing GIC or an inheritance it would be better to invest it all at once (and live with the volatility).
It’s better to invest the sum all at once because, as many studies have shown, stocks rise over the long run. When money is averaged into a rising trend, it results in a higher cost base. For lump sums, dollar-cost averaging is an inferior strategy, concludes York University professor Moshe Milevsky in his book Wealth Logic.
If you have only a regular amount to invest each period, then the technique looks more reasonable. But is it the still best way to average in a position? Not necessarily.
For example, there is value-cost averaging, which is described by Michael Edleson in Value Averaging: The Safe and Easy Strategy for Higher Investment Returns . The basic idea is to adjust contributions to keep a targeted value constant.
So, if the value of your holding has fallen 5 per cent below target, the deposit in the next period is increased by an amount to bring your holding back up to target. As a result, you would be acquiring more units at low prices and fewer at high prices, compared to dollar-cost averaging.
Indeed, says Wikipedia, American financial theorist and money manager William J. Bernstein has stated that value averaging is superior to lump sum investing and dollar cost averaging for deploying a large sum into a portfolio