What Is Value Averaging?
Let me explain value averaging (VA) to you—it's an investing strategy that operates much like dollar-cost averaging (DCA) by involving steady monthly contributions, but it stands apart in how it handles the amount of each contribution. With value averaging, you set a target growth rate or a specific amount for your asset base or portfolio each month, then you adjust the next month's contribution based on whether you've gained or fallen short of that original asset base.
So, rather than putting in a fixed amount every period, a VA strategy bases your investments on the total size of your portfolio at each interval.
Key Takeaways
- Value averaging is an investment strategy that involves making regular contributions to a portfolio over time.
- In value averaging, you would invest more when the price or portfolio value falls and less when it rises.
- Value averaging involves calculating predetermined amounts for the total value of the investment in future periods, then making an investment sized to match these amounts at each future period.
Understanding Value Averaging
The primary aim of value averaging (VA) is to pick up more shares when prices are dropping and fewer when they're climbing. This mirrors what happens in dollar-cost averaging, but the impact is more subtle there. Various independent studies indicate that over multiple years, value averaging can yield slightly better returns than dollar-cost averaging, though both methods will track closely to overall market returns during the same timeframe.
In dollar-cost averaging (DCA), you always commit the same amount periodically. You end up buying more shares when prices are low simply because they cost less. By contrast, with value averaging, you deliberately buy more shares because prices are lower, and the strategy directs the majority of your investments toward acquiring shares at those reduced prices.
Value averaging might appeal to you more or less than a fixed contribution schedule because it offers some protection against overpaying for stocks when the market is overheated. If you steer clear of overpaying, your long-term returns will outperform those of investors who plowed in set amounts regardless of market conditions.
Example of Value Averaging
Consider this example: suppose your goal is for the portfolio to grow by $1,000 every quarter. If after one quarter, the assets have increased to $1,250 (based on 100 shares from Q1 times the Q2 price of $12.50), you would add $750 to the account ($2,000 target minus $1,250 current) worth of assets. That $750 divided by the $12.50 share price buys you 60 more shares, totaling 160 shares. Then, 160 shares times $12.50 equals $2,000 value for Q2.
In the next quarter, your target would be account holdings of $3,000. This pattern repeats in subsequent quarters, and so on.
Tip
While there are performance variations between value averaging, dollar-cost averaging, and fixed investment contributions, each serves as a solid strategy for disciplined long-term investing—especially if you're planning for retirement.
Challenges to Value Averaging
The most significant hurdle with value averaging is that as your asset base expands, covering shortfalls can become overwhelmingly large. This is particularly relevant in retirement plans, where you might not have the capacity to fund a shortfall due to annual contribution limits.
One solution is to dedicate a portion of your assets to a fixed-income fund or funds, then shift money in and out of equity holdings based on the monthly targeted return. This approach means that instead of injecting new cash, you can draw from the fixed-income side and direct higher amounts to equities as required.
Another issue with the VA strategy is that in a declining market, you might exhaust your funds, rendering the larger required investments unfeasible before a recovery. This can worsen after the portfolio has grown, as drawdowns might demand much larger capital infusions to maintain the VA approach.
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