Are you new to investing? Are you building your portfolio and want to invest a certain amount every month? Then this section is for you. We are going to “Value Average (VA)” which is similar to dollar cost averaging (DCA) but provides a higher rate of return in a long-term investment program.
The premise is simple, instead of using a “fixed dollar” rule (“buy $100 of stock each month”), the value averaging goal is to make the value of your stock holdings go up by $100 (whatever amount you choose) each month. We focus on value instead of investment cost.
Table 1 shows the results of wanting your value to go up approximately $100 every month. Starting in Dec 2016 you buy 6 shares our hypothetical stock, ZigZag corp., for $108 (we can’t buy fractional shares). In January, the stock is relatively unchanged and we purchase $90 worth of stock. But look at March, the price of the stock jumped and we sold stock. Obviously, you could just keep the share and not make any contribution this month. When the stock price falls, we need to make up the lost value and purchase more as we do in December 2017. Finally, another big rise in Dec 2018 allows a large sale of stock.
Using this strategy, we have an average cost per share of only $21.36 compared to an average share price of $22.49. VA has us buying more shares than usual when the price is low.
There is one problem with both DCA and VA over the long-term, they both fail to take market growth into consideration. Suppose, instead of a fixed dollar amount of growth, you purchase a constant number of shares (CS) each month. When the share price goes up, you obviously pay more money to purchase the same fixed number of shares. This is the market effect, as the market grows, your required monthly investment grows. Another problem with both DCA and VA is that they do not keep up with inflation.
Over time, DCA continues to buy less and less of the market to the point where the additional contributions are insignificant. With the CS strategy both your incremental investment (price of stock) and the value of your holdings keep up and move with the market. With DCA, the holdings are keeping up, but the relative value of your new investments shrink, you are buying fewer shares as the share price rises. With VA both the new money and old money goes down due to periodic selling of shares.
Lump Sum Investments
Let’s look at investing a few different ways. Historically and statistically, investing the whole amount at once is the best. The market has historically earned 10.71% since 1871 and 15% since 2009. What if you had a lump sum to invest today and then just let it grow using compounded interest. If your goal is to have $100,000 for college in 18 years, how much do you need to invest today at 10% annual return? That would be $17,986.
What if you don’t have $18,000 to invest right now? Let’s figure out how much you need to invest monthly to have $100,000 in 18 years at 10% annual interest. Using the power of compounded interest, you need to invest $174.87 monthly, meaning a total investment of $37,772 to yield $100,000 in 18 years.
Readjustments – correcting for bad years or falling behind
The above method works great if there is steady growth like an annuity. Unfortunately, the stock market is not steady. Some years it grows fast, some years it loses. During losing years we need to invest more. For simplicity, let’s say we invest $100/month for 20 years with a compounded monthly interest rate of 1%. You would invest $24,000 total but you would accumulate $98,925.
What if we hit a bad year right off the bat and our investment drops by 17%? Then, for the remaining 19 years we must increase our monthly investment from $100 to $103 or $104. Another example would be at year 10 we are behind $1,200 in our investments. Now, you must invest $122 per month for the remaining 10 years.
These are situations that will happen in your investment career and needs to be accounted for. VA does this for you automatically, DCA does not.
In the above example, we invested at a constant rate of $100 per month for 20 years. However, due to inflation and market growth, $100 may be a lot today, but a lot less in 20 years. So, what if you allow for an increase of 0.5% every month in the amount you invest. In this case, you would start your investment at roughly $66/month. By the final month your monthly contribution would have increased to $218.
While the calculations to adjust your investments for DCA can be complex, constantly calculating future values, it is easy to do with VA. By its very nature, there is a portfolio readjustment at every investment period, as you maintain the target value path.
Here is the formula to calculate value in the future which includes growth and average monthly returns:
Vt= C x 1/(r-g) x [(1+r)t – (1+g)t]
r = stock market monthly growth.
g = monthly contribution growth.
C = monthly contributions.
t = time in months.
Vt = value of the portfolio at the specified number of months.
Let’s start with some assumptions. First, suppose that we use the markets historical average of 10% to 12% annual and we are willing to increase our monthly contributions by 0.5% each month. That’s approximately 1% monthly market growth and 0.5% growth in contributions. Here is the same spreadsheet from above with growth factored in.
When you compare the two tables, you will notice that at the end you now have nearly $500 more in equity AND your IRR has increased from 20.5% to 20.8%. Your total shares is now 113 instead of 94. Adding growth to the equation gets you to your end target a lot faster, and smoother.
I have prepared a spreadsheet that you can download and use substituting in your own numbers. It should be up in the next few days.
James Krider, MD
Dr. James C Krider is a practicing family physician in Apple Valley, CA. Dr. Krider is a licensed insurance agent in the states of California (0I65488) and Nevada specializing in Medicare Advantage and Life insurance, an important aspect of wealth planning.