The first step is always the hardest. And individual investors taking their first steps in an investment program must also confront a sea of stock market uncertainty. Some plunge headlong into the market with all their savings. Others barely wet their feet before heading back to the safe shores of their money market funds. The problem, however, with these two all-or-nothing approaches is one of timing—the risk of entering the market at a high point in the market cycle.

Dollar cost averaging and its variations, such as value averaging, offer investors an alternative, allowing them to ease into the market over time, which reduces the timing risk. The mechanical aspects of averaging provide an investing basics discipline, require no market forecasts and are relatively simple to initiate. Most mutual funds offer automatic investment and exchange programs—a cruise control for your investment plan that eliminates the more routine aspects of maintaining an averaging plan.

The Concept

Dollar cost averaging is a basic investing concept: Invest a fixed amount at equal intervals and continue to do so over a long period. The result is that more shares of a stock or mutual fund are purchased when prices are relatively low and less are purchased when prices are relatively high. This can result in lower average per share cost over time.

Value averaging is a variation: Instead of investing a fixed amount each interval, the amount invested varies so that the total value of the investment increases by a fixed sum or percentage each interval. If share price increases alone cause the total value of the investment to increase above the planned fixed amount, then the investor must sell shares instead of adding to the investment.

Neither approach requires a forecast of market direction. And with both plans, the basic discipline of periodic investment during all market situations and the continuation of the plan over long investment periods—of five years, 10 years, 20 years or even longer—provides substantial benefits, not the least of which is simply getting started in an investment program in the first place. In fact, many investing basic primers tout the value of dollar cost averaging simply because it forces you to be in the market.

Investors who should use dollar cost averaging or value averaging include:

Any investor with a pool of cash or periodic cash flows who seeks to invest in a risky asset, who has a long-term investment horizon, and who feels that he cannot forecast short-term moves in the market.

Any investor who is having difficulty finding the right moment to move into the market (or back into the market if he was temporarily out of the market).

One key to the successful use of any basic investment averaging approach is to choose an appropriate long-term horizon. In order to avoid the potential disaster of placing a substantial portion of your portfolio in risky investments at the high point of a market cycle, take a minimum of two years, investing monthly or quarterly, to complete the move into the market. Five years is an ideal period, albeit a bit too long for many impatient investors.

Those investors without a significant pool of cash currently available but who instead have cash periodically available are spared the temptation of rushing a large sum into the market all at once. These investors are already structured for dollar cost averaging, but without a basic investing plan, they may never start an investment program.

Another consideration is the frequency of the investments. Any periodic interval could be used and, of course, any amount or value. Investing often enough over a uniform time interval is important and every quarter, two months, or every month is reasonable. Investing weekly, however, is probably overkill, while waiting every six months or every year to invest is too infrequent and may defeat the basic benefits of diversifying the investments over time in an ever-changing market.

How They Work: An Example

Table 1 and Table 2 show investing basics examples of dollar cost averaging and its more market-tuned cousin, value averaging, illustrating the structure of each investment plan and highlighting the differences. The investments in the example are a broad-based stock index fund and an aggressive growth mutual fund; the time period covered is five and a half calendar years; the investment frequency is quarterly. These two basic averaging approaches could be used to invest in individual stocks as well.

Table 1. Stock Index Fund Quarter NAV Dollar Cost Averaging ($1,000 invested each quarter) Value Averaging ($1,000 quarterly increase in value) Amount

Invested

($) No. of

Shares

Bought Total

No. of

Shares

Owned Total

Invested

($) Total

Value

($) Amount

Invested

($) No. of

Shares

Bought Total

No. of

Shares

Owned Total

Invested

($) Total Value ($) Y1, Q1 24.27 1,000 41.2 41.2 1,000 1,000 1,000 41.2 41.2 1,000 1,000 Y1, Q2 29.22 1,000 34.22 75.42 2,000 2,204 796 27.25 68.45 1,796 2,000 Y1, Q3 30.52 1,000 32.77 108.19 3,000 3,302 911 29.85 98.3 2,707 3,000 Y1, Q4 32.31 1,000 30.95 139.14 4,000 4,496 824 25.5 123.8 3,531 4,000 Y2, Q1 24.65 1,000 40.57 179.71 5,000 4,430 1,948 79.04 202.84 5,479 5,000 Y2, Q2 25.67 1,000 38.96 218.67 6,000 5,613 793 30.9 233.74 6,272 6,000 Y2, Q3 27.15 1,000 36.83 255.5 7,000 6,937 654 24.09 257.83 6,926 7,000 Y2, Q4 27.06 1,000 36.95 292.45 8,000 7,914 1,023 37.81 295.64 7,949 8,000 Y3, Q1 27.18 1,000 36.79 329.24 9,000 8,949 965 35.49 331.13 8,914 9,000 Y3, Q2 28.74 1,000 34.79 364.03 10,000 10,462 483 16.82 347.95 9,397 10,000 Y3, Q3 31.09 1,000 32.16 396.19 11,000 12,318 182 5.86 353.81 9,579 11,000 Y3, Q4 34.2 1,000 29.24 425.43 12,000 14,550 -100 -2.93 350.88 9,479 12,000 Y4, Q1 33.64 1,000 29.73 455.16 13,000 15,312 1,196 35.56 386.44 10,675 13,000 Y4, Q2 32.38 1,000 30.88 486.04 14,000 15,738 1,487 45.93 432.37 12,162 14,000 Y4, Q3 34.21 1,000 29.23 515.27 15,000 17,627 209 6.1 438.47 12,371 15,000 Y4, Q4 29.32 1,000 34.11 549.38 16,000 16,108 3,144 107.23 545.7 15,515 16,000 Y5, Q1 31.24 1,000 32.01 581.39 17,000 18,163 -48 -1.53 544.17 15,467 17,000 Y5, Q2 35.51 1,000 28.16 609.55 18,000 21,645 -1,323 -37.27 506.9 14,144 18,000 Y5, Q3 35.23 1,000 28.38 637.93 19,000 22,474 1,142 32.41 539.31 15,286 19,000 Y5, Q4 36.91 1,000 27.09 665.02 20,000 24,546 94 2.55 541.86 15,380 20,000 Y6, Q1 39.31 1,000 25.44 690.46 21,000 27,142 -300 -7.64 534.22 15,080 21,000 Y6, Q2 38.09 1,000 26.25 716.71 22,000 27,299 1,652 43.36 577.58 16,732 22,000 Y6, Q3 38.58 1,000 25.92 742.63 23,000 28,651 717 18.58 596.16 17,449 23,000

Dividend and capital gains distributions are ignored to simplify the presentation, but for investors, the reinvestment of all dividends and distributions should be part of any investment plan.

The examples use a $1,000 quarterly contribution for the dollar cost averaging approach: $1,000 is invested each quarter at whatever the prevailing price of the security is at that time.

For the value averaging approach, a $1,000 quarterly increase in value is used: The amount invested quarterly varies such that the total value of the investment increases by $1,000 each quarter; if the share price rises enough to cause the investment to increase by more than $1,000 during the quarter, shares would be sold to hold the increase in value to $1,000 for the period. For example, in the first quarter of Year 3, Aggressive Growth Fund jumped from a net asset value of $7.06 to $8.34 (Table 2). To keep the increase in value to $1,000, the following basic calculations must be made: At the end of the quarter, the investor held 1,274.79 shares with a net asset value of $8.34 before any changes, so the value of the portfolio would have been $10,632 (1,274.79 x $8.34, rounded), an increase of $1,632, or $632 more than the planned $1,000 increase. That means that 75.75 shares ($631.73 divided by $8.34, rounded) would have to be sold.

Table 2. Aggressive Growth Fund Quarter NAV Dollar Cost Averaging ($1,000 invested each quarter) Value Averaging ($1,000 quarterly increase in value) Amount

Invested

($) No. of

Shares

Bought Total

No. of

Shares

Owned Total

Invested

($) Total

Value

($) Amount

Invested

($) No. of

Shares

Bought Total

No. of

Shares

Owned Total

Invested

($) Total Value ($) Y1, Q1 8.92 1,000 112.11 112.11 1,000 1,000 1,000 112.11 112.11 1,000 1,000 Y1, Q2 12.55 1,000 79.68 191.79 2,000 2,407 593 47.25 159.36 1,593 2,000 Y1, Q3 12.07 1,000 82.85 274.64 3,000 3,315 1,077 89.19 248.55 2,670 3,000 Y1, Q4 12.97 1,000 77.1 351.74 4,000 4,562 776 59.85 308.4 3,446 4,000 Y2, Q1 6.23 1,000 160.51 512.25 5,000 3,191 3,079 494.17 802.57 6,525 5,000 Y2, Q2 6.89 1,000 145.14 657.39 6,000 4,529 470 68.26 870.83 6,995 6,000 Y2, Q3 7.59 1,000 131.75 789.14 7,000 5,990 390 51.44 922.27 7,385 7,000 Y2, Q4 7 1,000 142.86 932 8,000 6,524 1,544 220.59 1142.86 8,929 8,000 Y3, Q1 7.06 1,000 141.64 1073.64 9,000 7,580 931 131.93 1274.79 9,860 9,000 Y3, Q2 8.34 1,000 119.9 1193.54 10,000 9,954 -632 -75.75 1199.04 9,228 10,000 Y3, Q3 9.21 1,000 108.58 1302.12 11,000 11,993 -43 -4.69 1194.35 9,185 11,000 Y3, Q4 10.26 1,000 97.47 1399.59 12,000 14,360 -254 -24.76 1169.59 8,931 12,000 Y4, Q1 8.53 1,000 117.23 1516.82 13,000 12,938 3,023 354.44 1524.03 11,954 13,000 Y4, Q2 8.16 1,000 122.55 1639.37 14,000 13,377 1,564 191.66 1715.69 13,518 14,000 Y4, Q3 9.47 1,000 105.6 1744.97 15,000 16,525 -1,248 -131.74 1583.95 12,270 15,000 Y4, Q4 7.94 1,000 125.94 1870.91 16,000 14,855 3,423 431.16 2015.11 15,693 16,000 Y5, Q1 9.3 1,000 107.53 1978.44 17,000 18,399 -1,740 -187.15 1827.96 13,953 17,000 Y5, Q2 13.09 1,000 76.39 2054.83 18,000 26,898 -5,928 -452.86 1375.1 8,025 18,000 Y5, Q3 12.28 1,000 81.43 2136.26 19,000 26,233 2,114 172.13 1547.23 10,139 19,000 Y5, Q4 14.56 1,000 68.68 2204.94 20,000 32,104 -2,528 -173.6 1373.63 7,611 20,000 Y6, Q1 17.34 1,000 57.67 2262.61 21,000 39,234 -2,819 -162.56 1211.07 4,792 21,000 Y6, Q2 16.14 1,000 61.96 2324.57 22,000 37,519 2,453 152 1363.07 7,245 22,000 Y6, Q3 14.36 1,000 69.64 2394.21 23,000 34,381 3,426 238.6 1601.67 10,671 23,000

While dollar cost averaging is unchanging, value averaging forces sales when prices rise sharply and forces larger purchases—more shares purchased—when prices fall. For example, in the fourth quarter of Year 4 the share price of Aggressive Growth Fund fell to $7.94 from $9.47 the previous quarter. That resulted in a $3,423 investment under the value averaging approach. Although there was a much bigger price drop in the first quarter of Year 2, few shares were held at that time, so the increased investment required was less, at $3,079. With a volatile market or a volatile investment, or both, as was the case with Aggressive Growth Fund in Year 4, the $3,423 additional required investment was followed two quarters later, after a price run-up, by a redemption (a sale of shares) of $5,928. The experience for Stock Index Fund is similar, but because Stock Index Fund is less volatile than Aggressive Growth Fund and had a lower return for the period, the investments and redemptions are of a smaller magnitude under the value averaging approach.

The End Results

Under the value averaging approach, the ending total value will be the periodical value increase times the number of periods—in this example, $1,000 times 23 quarters, for a total ending value of $23,000. In other words, when you start the value averaging program, the ending amount is known, but the amount to be invested isn't.

Under the dollar cost averaging approach, the total value at the end of the period could be any value, but the total amount invested is equal to the number of periods times the periodic sum—in this example, 23 quarters times $1,000, for a total amount invested of $23,000. When you start the dollar cost averaging program, the amount to be invested is known, but the ending amount isn't.

Keep in mind that the basic investing goal of value averaging is to increase the portfolio by a fixed amount each period, and it may take substantial total amounts invested to do so, conceivably much more or much less in total than the certain dollar cost averaging sum.

Which approach works best? While either basic investing approach could dominate over any time period, value averaging probably has the edge because it is more aggressive. However, value averaging requires more monitoring, more transactions costs, and because it triggers sales, potentially more tax consequences. Value averaging can be modified so that no sales take place, with future value increases adjusted to compensate. Also, the loss potential is greater for value averaging because the total amount that is required to be invested is unconstrained.

Please note that you cannot judge which approach did best in the investing basic examples simply by looking at ending portfolio values because the amounts invested and the timing of the investments differ for the two approaches. The calculation to determine performance is called an internal rate of return calculation that takes into consideration all the cash flows and their timing. These returns are given at the bottom of each example.

A Practical Approach—Mutual Funds

Dollar cost averaging has been made even easier by mutual funds that offer an automatic exchange plan. Under these basic investment plans, money can be moved periodically and automatically from a money market fund to any other fund in the family, or between any two funds in the family.

Additionally, some funds have a systematic withdrawal plan which allows the shareholder to automatically withdraw money from their fund account. Withdrawal plans sometimes give investors the choice of transfering the money into their checking account or into another fund within the fund family, although often this option is explained only on the account application form.

Someone with a lump sum to invest might put the money in a money market fund and set up an automatic exchange program with an equity fund, for example. If a fund you are interested in is not listed as providing this service, don't give up—check with the fund; these services are being initiated continuously.

(Keep in mind that automatic exchange plans will not be useful for value averaging, since the amounts vary each investment period. To use a value averaging approach, look for a fund that allows telephone exchanges.)

Dollar cost averaging and value averaging provide a clear path for investors to follow. With the pathway marked, taking the first few steps of a basic investment plan should be that much easier.