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WHAT IS VALUE AVERAGING

Value Averaging is a combination of its better-known cousin - "dollar-cost averaging" - and a process known as "portfolio rebalancing." 

The value averaging method, has been shown to produce better results over time than the old "dollar-cost averaging" method. Edeleson has tested VA using simulations to compare VA to DCA and purchases of a constant number of shares in each investment period. Without considering possible differences in risk, Edleson concludes:

  • “There is an inherent return advantage of value averaging (over dollar-cost averaging and purchase of a constant number of shares).”

  • “It’s about as close to ‘buy low, sell high’ as we’re going to get without a crystal ball.”

Edleson, who was also a managing director at Morgan Stanley (MS), relied on one crucial piece of information that was missing from the "dollar-cost averaging" method to come up with "value averaging." By considering a portfolio’s expected rate of return (something that the "dollar-cost averaging" method neglects), the value averaging method helps to identify periods of over and underperformance.

When a portfolio is underperforming, share prices are likely to be low. And that’s when you’ll be investing more to make up for the underperformance. When the portfolio is outperforming your target rate return, share prices are likely to be high. That means it is not a good time to buy and you could even sell for a profit, provided you maintain your predetermined average growth rate.

Value Averaging is a nice way to ensure you follow one of the most well known investment mandates: Buy low and sell high. The method is particularly valuable during times of high volatility to help ensure investors maintain discipline in their investing. And in these difficult market conditions, it’s certainly worth considering.

“The rule under value averaging is simple: ... make the value not (the market price) of your investment go up by a fixed amount each month.”

 

HOW VALUE AVERAGING WORKS

Basically, the idea behind dollar-cost averaging is that instead of investing a sum of money all at once, you invest it a little bit at a time over a specific period. So, for example, if at the beginning of the year you had $12,000 that you wanted to invest in stocks, you might invest $1,000 each month over the course of a year instead of investing it all at once. This is essentially Dollar Cost Averaging where the idea is that you reduce risk because you're buying stocks at a variety of prices throughout the year instead of buying all the shares at a single price. Dollar cost averaging is a “Buy low, buy less high” strategy, as there are no rules for selling.

Value Averaging works a bit differently. With Value Averaging, you first figure out how much money you will need to accumulate for a goal such as retirement. Then, based on the annualized return you expect to earn on your investments, you figure out how much you must invest each month to achieve that goal.

So let's say you have a goal of accumulating $500,000 over the next 20 years. If you figure you can earn an annualized 8 percent, then you would need to put away about $875 a month. You can then chart your progress month by month towards that goal. Here's where the "value" part of value averaging comes in. Let's say that, at the end of the first year, instead of having the $10,950 you should have to be on track toward your goal, a downturn in the markets leaves you with just $10,000.

That would mean that the next month, instead of investing your usual $875, you would invest an additional $950 to bring your portfolio's value to where it should have been to remain on track toward your goal. In fact, you would go through this process each month. In months where you fall behind, you would add to the amount you invest each month. And in months where your returns are higher than expected and your portfolio's value gets beyond where it needs to be, you would scale back your monthly investment, or even possibly end up selling some shares. Hence, value averaging provides sell signals so when properly applied, it should help us to "buy low, sell high". 

 

VA Example

 

VA Buy Sell graph

HOW VALUE AVERAGING DIFFERS AND WHY IT WORKS

While either approach (VA or DCA) could dominate over any time period, value averaging has the edge most of the time because it is more aggressive. However, value averaging requires more monitoring, has more transaction 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.

At first glance the VA strategy may not seem too different from DCA, however there are significant differences:

  • A large upward price swing often results in the sale of shares, instead of a purchase.

  • VA also results in a net average cost per share that is much lower than the average cost per share with DCA.

  • There is often a tendency to sell shares when the share price is high; the best DCA can do is buy fewer of the more expensive shares

  • VA takes a more extreme response to market dips and rises than does DCA. The return is enhanced greatly by the larger purchases at low prices and by the profit taking as shares are sold at generally higher prices.

  • VA forces you to avoid big moves into a peaked market or panic selling at the bottom

  • VA tends to provide the highest returns in the stock market over short to immediate term investment periods.

Value Averaging (like DCA) helps investors to tide over market volatility without worrying too much about market timing.

 

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