We had earlier affirmed that Dollar Cost Averaging is a good strategy for investors who have a lower risk tolerance. Dollar Cost Averaging advocates, for the same amount of money, to be able to buy more units of shares when the price drops and lesser units when the price rises.
There is no need to time the market for the best entry and volatility is much lower as compared to Lump Sum investing. If you invest a lump sum into the market all at once, you run the risk of buying at or near the peaks. It is however is more or less evened out over a long-term investment horizon.
Dollar Value Averaging
Dollar Value Averaging instead aims to invest more money to buy even more units when the share price falls and less money to buy even lesser units when the share price rises. This means that the amount of money injected in each investment period is not constant. The investor has to pre-determine the overall value of investment in future periods, then by making adjustable periodic investment to match these values at each future period.
For example, suppose the value of your investment rise by $500 monthly with additional capital injection. Say you invest at $10 a share for the first investment period of $500. You determine that the value of your investment will rise to $1,000 in the next period.
If the share price is then $12.50, your original position is worth now $625, which only requires you to invest $375 for the second investment period for overall portfolio value to be at $1,000. This execution is systemically executed until the end value of the portfolio is reached. Therefore, instead of investing a fixed amount for each period, Dollar Value Averaging carries out investments based on the overall value of the portfolio in each period.
One potential flaw exists however, for Dollar Value Averaging. In a beaten market, an investor might actually run out of cash to make the larger required investments before the situation reverts. This flaw amplifies with a larger portfolio, as substantially larger investment is required to continue executing Dollar Value Averaging.
From an overall perspective, this strategy ensures that capital injection is largely spent on acquiring new shares at lower prices, as more money is spent when share price is lower and restricts capital injection when price gets higher. This strategy generally produces significantly higher investment returns over the long term.