Jacob became financially independent at age 30 by reducing his expenses, saving and investing 75 percent of his paychecks to provide enough passive investment income for the rest of his life. He no longer works for a living. He blogs about how to reach financial independence and many other things on Early Retirement Extreme.
Many are familiar with the mechanical method of dollar cost averaging. In dollar cost averaging (DCA), equal dollar amounts are invested monthly, typically in the stock market. DCA is a very useful method for people who are using the stock market as an investment vehicle and relying on equally sized paychecks for their investments.
Issues with Dollar Cost Averaging
There are a few problems with DCA , though. First of all, the stock market tends to rise much faster than paychecks. This means that the paycheck contributions simply don’t keep up. In other words, later paychecks, say 20 years from now, simply matter much less than the early paychecks.
Second, DCA is a process of always buying. DCA does not have a sell strategy. The closest sell strategy is one of reverse DCA where equal amounts are taken out every month. Everything presented as an advantaged when putting money in will conversely count as a disadvantage when money is taken out. DCA investors rejoice in stock market drops because it means they buy more shares, retirees suffer greatly because stock market drops mean they have to liquidate more shares at market low points.
Another Option: Value Cost Averaging
Another mechanical strategy is a value cost averaging. Instead of buying $1,000 worth of shares every month, the idea is to increase the size of the portfolio by a fixed amount regardless of what the market is doing. Say the current portfolio is worth $10,000. The goal may be to grow it by 10 percent per year. If the portfolio is worth $9,000 at the end of the year, $2,000 is contributed. If on the other hand the portfolio has increased to $12,000 (that is a 20 percent growth), $1,000 is taken out.
As such, value cost averaging automatically sells stock when prices go up rapidly under the presumption that they are now too high and stocks should be sold. Of course, the tricky part is to determine the percentage increase. Value cost averaging does not offer an answer to this question. It is this number which makes VCA more flexible.
The number can be set to grow the portfolio to a fixed end goal. For example, if the goal is to double it in 10 years, the number would be about seven percent by the law of 72. Another way is to estimate the long time average growth rate of the assets in one’s portfolio and use that under the assumption that returns are mean reverting.
