Monday, November 26, 2007

Dollar Cost Averaging (DCA) gets beat by Value Averaging (VA)!

The results are in and DCA loses in the stretch. Ah darn, I love DCA. Its mindless, emotionless, and easy. Besides who ever heard of VA?

The VA approach sets a target growth rate and then adjusts new deposits based on the performance of the fund. Huh? Let's say you want a 12% return that equates to 1% growth per month. Okay, now you invest $1000 and it grows in one month to 1015 or 1.5%. This exceeds your target, so next month you adjust your monthly contribution down 0.5% to 995. Conversely, if the fund performance lags the 1% target, you increase your investment by the corresponding dollar amount.

So is it worth changing to VA?
5000 Monte Carlo simulations later and the answer is – “It is optimal to follow the 401(k) value-averaging strategy with a target annual growth rate between 8 percent and 12 percent.”

The table shows that 67% or a majority of the time (for 5000 simulations) the VA approach beats DCA. Given 30 years or 360 months using a target rate of 1% per month and monthly contributions of 1000, the mean final value of the DCA portfolio is 7.8% less than the VA portfolio. Who would have thought such a small change could make that much difference? I was skeptical about such a large differential. I created a spread sheet, ran a few test cases and although VA did have better returns than DCA, I did not see the differences of the magnitude shown in the table.

Whats so cool about VA?
It makes me feel like I am in control! I am the decider and after I finish my calculations every month I will direct a specific amount of money into my retirement account. I am no longer just standing by while the market whips my funds around. I am actively managing my finances!

Blinded by science
The data is staring right at you. A logical Personal Financier would change from DCA to VA, right? Ugh. Okay, I pledge that I will change at least one DCA account to VA this month.

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