Value cost averaging is a terrific savings mechanism that is guaranteed to increase your wealth all while simultaneously reducing the emotion of buying and selling your assets. On top of this, the scheme goes hand in hand with many of the top robo-advisor platforms and further leverages their low cost management fees and free transaction costs. Sure, it has a few downsides which we will get into, but if you can steer through these, you’re guaranteed to grab more than your lion’s share of the market returns.
What is Value Cost Averaging?
Value cost averaging is a savings and investing scheme related to, but just a bit different from dollar cost averaging. Whereas with DCA you invest a set amount on a regular interval, with VCA you increase your portfolio by a set amount on a regular interval with the aim of meeting a prescribed target value. While this may sound the same, it is actually very different and the execution of the scheme highlights the difference.
Remember, we want to increase the portfolio value by a certain amount on each interval. For example, we want the portfolio to increase by $67 in total value each month. This means the amount contributed each interval will change depending on how much the portfolio has risen or declined.
Let’s Start with $10,000
Say we have a portfolio starting balance of $10,000 and we project and assume that this will grow by 8% a year. This means at the end of the first year we expect this portfolio will be valued at $10,800. Or in other words, if things grew smoothly, we should expect it to climb by roughly $66.67 each month.
But Nothing is Smooth
However, as we all know, this will seldom happen. Say at the end of the first month the portfolio is valued at $9,942. Not only are we not even close to $10,067 but we have lost ground. Sure, over time we could expect to cover this lost ground and get back on track, but with value cost averaging, we have an opportunity here.
Get it Back on Track
With DCA we would only add $67 no matter what, but with VCA we add what is needed to get it back on track this month. So, let’s go ahead and add $125 and get the portfolio up to that target $10,067. Not only is this helping by keeping us on track, it is taking advantage of a recent market pullback and we are picking up assets on a discount as compared to the previous month.
Extreme Example
Now let’s assume on month two, our portfolio jumps an its now valued at $10,200. Now we are actually ahead of where we need to be and we actually need to sell and pull it back. This month we would sell $66 and bring it back down to the targeted $10,134. Put the cash on the side and get it ready for future down months.
In practice the variance is not this much. One month you’re adding $70, while the next your adding $62. However, in the end you’re buying more when prices are down and buying less when prices are high.
Image Caption: This chart does a great job of showing what we are trying to achieve above and below the value path line.
What Kind of Extra Performance Can I Expect?
In study after study the increased performance over random investing and dollar cost averaging is evident and actually to be expected. First, because you’re buying more when prices are cheap. Second, you’re actually encouraged to sell when prices cross an upper limit, and this type of trading is very conducive to wealth building and executing on the mantra of buy low / sell high.
You can typically expect to improve your performance by 0.5% to 1.0% over a simple dollar cost averaging strategy
What are Some of the Drawbacks?
Yes, it is not without its flaws, and hence why its not advertised or promoted with average retail investors. Firstly, with the selling, it can incur taxes that will more then negate the benefits so its best done in a tax deferred or advantaged account. Secondly the regular investment amounts are rarely the same so you’re investing a different amount each month or two-weeks. This can make budgeting a bit more challenging. Thirdly, during strong market downturns or crashes, you can literally run out of money! So to counter this, investors will pull back and this will also negate the benefits this scheme provides.
How Best to Implement It?
In my opinion, the best way to implement this is with a robo-advisor where you can add a set amount very each month and let them handle the minutia of which funds to buy and sell. This let’s you focus on your total portfolio value and worry more about the increases and decreases on the broader sense.
Step 1: Start with a Starting Balance
First thing to do is to already have an investment portfolio balance running with a service provider you know and trust. Personally, I love WealthSimple for this purpose. I can manually add an amount to my tax deferred account each month and keep things on track. They handle all the backend trades and money movements to balance and allocate the portfolio per my risk tolerance and I love the simplicity.
Step 2: Have a realistic target value in mind
Next, calculate your portfolio balance into the future given an assumed rate of return you would be happy with but is also realistic. A nice round number is that typical 10% number, but you should also keep in mind your normal contributions and bump it up from there. This is to say, your portfolio could increase by 10% a year and still return nothing simply by you adding 10% each year. So just be sure to take this all into account.
Below is a sample of what I’m talking about. The monthly return and contribution are outlined together to determine the target balance for each month. I would adjust the contribution (blue cells) up or down to make sure I stay on the target listed out in the yellow cells. Keep in mind, when I get smashingly good performance the contribution cell will go negative and I will sell.
Step 3: Divide and Conquer
After you have your monthly markers accurately calculated, then you just divide these over your regular investment intervals to make sure you know where you need to be each month or every two weeks.
Step 4: Have Liquidity on Hand
The most important part of this strategy and investment scheme is to keep plenty of liquidity on hand to assist with buying the dip that will happen during crashes and downturns. This is the most difficult part of this strategy and often where it falls apart. So just keep this in mind.
Value Cost Averaging Example for 2020
Image Caption: 2020 offered the perfect example of just how effective this strategy can work, but also how difficult it can be.
Same Dollar Cost Averaging For 2020
Image Caption: So while the portfolio value is higher with DCA, it did so with much more capital and much lower overall returns.
Value Cost Averaging Key Results and Conclusions
A properly executed value cost averaging strategy will provide superior returns over dollar cost averaging however it is more difficult to implement and execute.
This scheme requires more time and involvement from the investor, and requires the investor be capable of investing a variable amount each period. The key benefit of the VCA strategy comes from purchasing shares or units when they are cheaper and fewer shares when they are expensive. It is this flexibility that makes it more effective than simple a DCA strategy.
Useful for As Exit Strategy as Well
Another point to keep in mind is this strategy can be inverted and used for selling as well. So it can enhance returns when selling out of a position by selling more during good returns and selling less during bad returning months. So, just another tool or feather to keep in your hat for later in life.
Closing Thoughts and Wrap
Value cost averaging is one of the best ways to implement a well thought out and emotionally removed savings and investment schemes. It is better than dollar cost averaging by rewarding those who can buy the downturn, dip or crash. However, it takes a more active approach than the simple dollar cost average approach and requires a cash hoard on the side to be dipped into when needed.
For these reasons, and the variable contribution requirement, it is usually left alone and not practiced. However, if you are able to handle the liquidity requirements it can be a very rewarding investment approach and pay off in the long run.
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2 comments
I always wondered how VCA can make investment different. Thank you for putting the numbers and all the details. Really informative.
However, as you mentioned, I feel it is not easy to make it happen in real life. True for amounts like $10K, can be done, but when portfolio is big, there might not be enough cashflow from other incomes to top-up the portfolio.
I was lucky to have a lot of my fund in a maturing GIC just in Feb 2021 which helped in investing $40K in the 2-3 weeks of March meltdown. 1/3rd went in during the first week of the crash. 1/3rd during the dip, and 1/3rd through its recovery. I guess I mixed a DCA and VCA. Or maybe this is called Random. I don’t know. 🙂
Hey Vibrant – yes, it can be difficult in the execution and get to a point where the portfolio is too big to be supported. That’s great your GIC matured just in time to be of such huge benefit. I think it would count as random or DCA as you’re not targeting a specific value to hold?
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