Value Averaging Help Needed

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the11diesel
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Joined: Wed Sep 05, 2007 10:18 pm

Value Averaging Help Needed

Post by the11diesel »

Hey all, I've been reading about value averaging, and it really looks interesting, but I've got got one big question. For value averaging to work, you have to set a certain growth rate that you acts as your benchmark for how much money you'll invest, and how much you'll keep on the sidelines. I have absolutely no idea how to estimate a reasonable rate of return. I know that I could look at historical returns, but even so called 'experts' vary in their estimates of future stock market returns by as much as a couple of percentage points. As such, I'd love to know how fellow VA'ers were able to solve this problem, since picking an incorrect expected growth rate could prove very unprofitable (ie. picking too low of an expected growth rate would force you to unnecessarilly keep your dough out of a rising market). Thank you all very much, I very much enjoy reading this forum and I've learned a great deal.
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market timer
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Post by market timer »

I recently bought a copy of Edleson's Value Averaging book at an airport bookstore and read much of it on the flight. I eventually grew disappointed and decided to watch Mr. Woodcock instead.

The argument in favor of value averaging is disingenuous. The comparisons I saw were looking at internal rate of return, which will clearly differ from portfolio return depending on cash reserves. He works with realized equity returns to determine the value averaging path. This is the same flaw that makes reversion to the mean seem obvious when looking at a long term chart.

To make all this worse, Edleson has a PhD from MIT, so I'm sure he is aware of the flaws of his program. He admits that the internal rate of return for value averaging, unadjusted for equity growth, underperformed constant share purchases over the last 50 years. But then he says the reason is because this strategy was moving increasingly to cash. This is a red herring, because cash does not factor into his internal rate of return calculations. Simply put, the reason value averaging underperformed constant share purchases was because the 80s and 90s exhibited phenomenal returns, not because cash was a drag on returns. This was around the time I started watching the in-flight movie and regretted spending $20 on this book.
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czeckers
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Post by czeckers »

There is a table in the book (sorry I can't give you the page as I can't access it now) that bases the expected rate of return on the current 10-yr treasury bond rate, and the expected beta of your portfolio. If I recall correctly, the table went down to a 10yr treasury rate of 6.0% and stopped, so you will have to run the numbers to extrapolate to current rates.

The table assumed approx a 5.4% stock premium over the 10-yr treasury rate for a fund with a beta of 1.0. However he cautioned that given the current environment, the expected premium ought to be less and he advised lowering the premium to 4.2% (decrease r-value by 0.1 for monthly investments). Yesterday's yield was 3.66, add 4.2 gives you 7.8-7.9 expected return on an all stock portfolio. Probably not too far off the mark in the long run, but who knows. It's an expectation of the next 10 years' worth of performance... that's a long way to postulate.

If you aim for a lower expected return, you will be more likely to achieve your goal but will limit the potential upside if markets outperform your expectations. As for me, I am using this for my 403b account for which I'm already maxing out my contributions. I therefore decided to aim a bit higher in my expectations to allow for more of upside potential, with the understanding that if I turn out to be too optimistic in my projections, I may not reach the goal.

I struggled with it for a while, but in the end its not a precise science, and if you read the examples, he recommends reassessing things every couple of years. I ran the numbers using ranges from anywhere between 6 and 10%, and, because my portfolio is quite small right now, it doesn't make much of a difference in final value in 2 years when I plan to reassess. I like the technique so far though, in the first half of last year my MM fund was getting larger, and now I am finally beginning to deploy some of that cash back into the rest of the portfolio. Makes me feel good that I can buy more as values are going down.
The Espresso portfolio: | | 20% US TSM, 20% Small Value, 10% US REIT, 10% Dev Int'l, 10% EM, 10% Commodities, 20% Inter-term US Treas | | "A journey of a thousand miles begins with a single step."
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mudfud
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Post by mudfud »

market timer wrote:
The argument in favor of value averaging is disingenuous. The comparisons I saw were looking at internal rate of return, which will clearly differ from portfolio return depending on cash reserves. He works with realized equity returns to determine the value averaging path. This is the same flaw that makes reversion to the mean seem obvious when looking at a long term chart.

To make all this worse, Edleson has a PhD from MIT, so I'm sure he is aware of the flaws of his program.
I agree with your analysis, but I'm not really surprised. Popular financial books are littered with horrible math. Drives me nuts. Check out this abomination in Jason Zweig's version of "The Intelligent Investor" by Benjamin Graham.
http://www.diehards.org/forum/viewtopic ... 411#122411
"Are you sure you have tested an a priori hypothesis?" | | Image
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oneleaf
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Post by oneleaf »

the11diesel,
The VA book gives some guidelines in how to estimate future returns. However, there is no reason to expect Edleson's method to be superior to any other method. Although forecasting future returns is necessary as part of the VA strategy, the actual method for doing it is beyond the scope of the book.

The fact is there is no way to accurately predict future returns, and any method you choose will be wrong anyway. If future rates of return were reliably predicted, there would be no risk, and hence no reason for risk management strategies like VA. :D

market timer,
I am skeptical that VA will reliably boost returns, but I do believe it is a good way of reducing risk at the right time (when your portfolio is doing better than expected). It requires too many assumptions to believe it will actually help returns going forward. However, I do think VA is a good way for risk averse people to put money into the market.

I do think a better way to implement VA is to solely look at "real" returns, and not nominal returns. Setting nominal growth rates is less meaningful, imo, than setting real growth rates. But then it would need to have CPI adjustments every period and I'm still not sure what the best way is to implement it into the spreadsheet (in conjunction with my portfolio spreadsheet).
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market timer
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Post by market timer »

Oneleaf,
I bought the book wanting to be sold on the concept of value averaging, and actually believe in RTM. So, I think and hope you can improve returns from value averaging and similar strategies, but would have liked to have seen a better, more honest, argument.
Pangloss
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old thread

Post by Pangloss »

Hi the11diesel.

You might want to read an earlier thread on this discussion as well.

http://diehards.org/forum/viewtopic.php?t=4250

I've been thinking about value averaging for a while now, but I still haven't come to any decisions. Good luck with yours.
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Petrocelli
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Post by Petrocelli »

oneleaf wrote: I am skeptical that VA will reliably boost returns, but I do believe it is a good way of reducing risk at the right time (when your portfolio is doing better than expected). It requires too many assumptions to believe it will actually help returns going forward. However, I do think VA is a good way for risk averse people to put money into the market.
Oneleaf:

This is an excellent point. No one knows whether VAing or DCAing will work out better going forward. IMO, a big reason to value average is psychological. You take cash off the table in up markets to use on a future day. When we have bad markets, as we have this month, a person who value averages is sitting there with cash to invest.

I know my portfolio lagged last year due to cash drag. However, it may outperform this year because of that cash. How this works out in the long run is anyone's guess. However, I know that the cash gives me comfort and allows me to stay the course.
Petrocelli (not the real Rico, but just a fan)
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