Value averaging

Value averaging (VA), sometimes called dollar value averaging (DVA), is a mechanical technique to figure how much to invest every period, for example every month or quarter. It was popularized by Michael Edleson in a book first published in 1993 and now reissued. According to Edleson, "The rule under value averaging is simple: ... make the value not (the market price) of your stock go up by a fixed amount each month."

Value averaging is often presented as an improvement on dollar cost averaging (DCA).

Difference from dollar cost averaging

With DCA, the investor buys the same dollar amount every period, for example $100 of a certain fund every month. If unit prices raise, $100 then buys fewer units; if unit prices decrease, the investors acquires more units. The result is an average unit cost that is lower than the average unit price over the same length of time.

With value averaging, the amount to add every period is variable rather than constant. The investor targets a certain increase in portfolio value, for example, the fund balance should increase by $100 every month so enough money should be added (or taken out) to it to achieve that. After a drop in prices, VA purchases more units due to lower prices, but also increases the dollar amount to be invested; after a large price increase, VA may require selling some units. In other words, VA is more sensitive to price fluctuations than DCA, leading to mechanical “buy low, sell high” behaviour.

Implementing value averaging

VA uses mathematical formula to control the amount of money invested in a portfolio over time. VA uses spreadsheets to determine how much to allocate to various asset classes. Because the required dollar inflows of VA are volatile and unpredictable, “Edleson envisages investors holding a ‘side fund’ containing liquid assets sufficient to meet these needs”. This buffer may result in a cash drag, i.e. lowering returns relative to investing all available money immediately as it becomes available.

One statistical study concludes that “value averaging does actually provide a performance advantage over dollar-cost averaging and random investment techniques, without incurring additional risk”, based on an internal rate of return (IRR) analysis. Subsequent work has suggested that although the IRR may be higher due to systematic biases, the expected profits are not higher and VA is actually inefficient. If a mechanical investment technique is sought for behavioural benefits (i.e. maintain savings discipline, minimize regret, avoid market timing or paralysis), then DCA is simpler due to stable cash inflows and less investor involvement.

Accumulation Phase

The investor begins by determining the size and frequency of their regular contributions, as well as a realistic estimate of the return generated by the entire portfolio. For example, an investor with a portfolio worth $10,000 decides that they will contribute $1,000 four times per year to their portfolio, and expects an annual return of 5% - equivalent to a quarterly return of 1.25%.

At the end of the first quarter, the expected value of the portfolio is calculated as follows:

$10,000*(1+.0125)+$1,000=$11,125

Regardless of the actual performance over this period, the investor will add enough money to bring the market value of the portfolio to $11,125. If the portfolio performed exactly as expected, the investor would contribute $1,000. If the portfolio under-performed, the amount added will be greater than $1,000. If the portfolio over-performed, the amount added will be less than $1,000. If the portfolio significantly over-performed, it may be necessary to sell in order to bring the market value of the portfolio in line with the expected value. This process is repeated each time the investor adds to the portfolio.

During periods of over-performance, excess cash is kept in a High-interest savings account (HISA) or equivalent to be used during periods of under-performance.

Rebalancing

Main article: Rebalancing

If the portfolio contains multiple asset classes, they will be rebalanced back to target allocations each time money is added to the portfolio. Suppose the investor in the above example has a target allocation of 40% bonds and 60% equities. When money is added at the end of the first quarter, the investor will rebalance as follows:

Bonds: $11,125*0.4=$4,450

Equities: $11,125*0.6=$6,675

In practice, this results in more money being added to under-performing asset classes and, potentially, a lower average cost per share.

Withdrawal Phase

Dollar value averaging can be used in reverse during the withdrawal phase, where the amount withdrawn will be greater during periods of market over-performance.

Spreadsheets

The Excel files that accompany Edleson's book are available, Excel Files for VA Book.xls.

See also

• Dollar cost averaging

Further reading

• Edleson, Michael A, Value Averaging: The Safe and Easy Strategy for Higher Investment Returns (Wiley Investment Classics), ISBN 978-0470049778
• Financial Wisdom Forum topic: " "Value Averaging" by Edelson: Back in print."
• Financial Wisdom Forum topic: "Value Averaging"

External links

• Value Averaging (again) | gummy-stuff
• sorta Value Averaging | gummy-stuff
• Value averaging, Bogleheads wiki
• Investopedia, Value Averaging: What it Means, Examples