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you have not already know what Dollar Cost Averaging means, please read "How do you know the time is right for investing?"
before reading this article.
So you say you want to do better than the middle-of-the-road performance that dollar cost averaging should provide. Yet you believe, as I do, that trying to time the market is inviting disaster. Is there a system that allows you to maintain the disciplined approach of dollar cost averaging and yet keeps your investment low when the markets are high and increases your investment when prices fall?
It seems there is. It's called value-cost averaging or VCA. VCA takes dollar-cost averaging one step further. Instead of investing a fixed amount into a mutual fund at fixed intervals, you vary your investments based on the price fluctuation of the fund. It's a relatively simple system, but it does require a bit more work than dollar-cost averaging.
To make value-cost averaging work you still can't try to second guess the market. You must invest on a regular basis, without fail. If you try to beat the system, by waiting out the market for a lower price, you become a market timer.
Here's how it works: First determine how much money you want to put into a mutual fund and at what interval (bimonthly, monthly, weekly) and invest your first payment. So far, it looks a lot like dollar-cost averaging.
Ah, but now the two systems begin to diverge. In a notebook write down the date and the price you paid per share. Let's say you invested $100 at $12.50 a share.
When it's time for your next investment you call the fund or check the price in the paper, write the date and price down and you do a simple calculation to determine the percentage difference between the two prices. For our example, the fund has risen 50 cents to $13 a share. If you divide .50 by 12.50 you'll see the price of the fund has increased by 4%. You then make out your next check to the fund for $96, or for 4% less than your initial investment.
The fund price is higher and you're buying less. In my VCA system you now adjust your $100 baseline to $13 a share, because if you didn't and your fund kept going up in value, you would eventually end up adding nothing. Then if the shares were still at $13 next investment time you would add your initial investment or $100.
If the share price declines, you add more than your base investment. For your third investment let's assume the share price fell to $12 or $1 below your new baseline price of $13. Rounded up that's an 8% decline. So your next investment should be $108 and in your notebook you change your $100 baseline to $12.
Using this very short term example, you would have already done better than you would have using dollar cost averaging. Using VCA your average price per share would be $12.46 compared to $12.49 per using dollar-cost averaging. The difference isn't terribly dramatic and yet if carried out over many years you could see a sizable increase over the results from dollar-cost averaging.
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