Value averaging

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The technique of value averaging is based on a formula (below) which guides how much one invests into a given investment at a specific time. The emphasis is on establishing a portfolio target value or “value path”. Value averaging seeks to increase the investment's value by this calculated amount on a periodic basis. Whenever a portfolio under-performs, the investors will therefore have to make a larger investment to make up for the under-performance. The converse is also true, and if the portfolio outperforms it’s targeted rate of return, then it is not the time to purchase more shares. Conceptually, value averaging can be thought of as combining the attributes of both dollar cost averaging and portfolio rebalancing. [1]

Value averaging was first promulgated by former Harvard professor, Michael E. Edelson, in his book, Value Averaging, published by Wiley in 1988. [2].

Methodology

The key idea is to create a Value Path which will describe the investment’s target level for each time period. You must simply make the proper investment or sale at each period so that the holdings are equal to the target value.

Let’s define our variables and show the formula for the Value Path.[3]

Table 1: Variables

  • t = Time period (can be months, quarters, years, etc.)
  • Vt = Target value of investment at time period t
  • C = Target initial contribution per period
  • r = Expected rate of growth per period of investment
  • g = Expected rate of growth per period of contribution
  • R = Average rate of growth of investment and contribution

To simplify the math, we will set R=(r+g)/2. Thus, R is just an average of the growth rates of the investment and the contribution amount.

Now, the formula for the Value Path:

Vt = C * t * (1+R)t

Now, you can simply use this formula to generate a Value Path for your investment. There are two different approaches for this depending on your needs. If you have a specific goal in mind, like you need $100,000 in 10 years for your son’s college expenses, you can start with the final value of the Value Path and use that to determine the required value of your initial contribution (C). So, for our example, if we were working with monthly time periods, we would want V120 = 100,000. Then, we solve V120 = C * 120 * (1+R)120.

On the other hand, if you have no specific savings goal but do know the amount of initial contribution that you are comfortable with, then you can plug in a value of C and solve for all the values of Vt.

We would suggest using a spreadsheet to create your Value Paths and track your progress. An important thing to remember about the Value Path is that you should remain flexible and update your Value Path if circumstances change. For instance, if the rate of growth for your investment or your ability to contribute changes, you should re-calculate the Value Path from your current point.

The Value Path formula depends heavily on your estimates of the rate of growth of the investment asset. Thus, it’s very important to provide as realistic rates as possible.

Illustrative example

The following spreadsheet table compares Value averaging and Dollar cost averaging:


(View Google Spreadsheet in browser, then File --> Download as to download the file.)


Here are some qualifying cautions to consider regarding value averaging :

  • Value averaging adds a growth factor (by formula, consisting of estimates of both the investment's return as well as growth in the contribution level) to the regular periodic investment of savings flows. If an investor's contribution amount is not expected to grow, this factor should be set at 0% so that investment growth is the sole growth variable.
  • Value averaging may require both purchases and sales of the underlying investment, based on the investment performance of the investment. The strategy requires a cash account for holding prospective purchases as well as any sales proceeds.
  • Value averaging sales can result in realizing taxable gains. Thus, one might restrict the strategy to tax advantaged accounts; or alternately, adopt a policy constraint forbidding or delaying sales in the taxable account.
  • You have to be careful in a declining market, as you will need to have additional funds available for investment. As time progresses and the account value grows, you may need even more funds to reach the amount required for the chosen period. If the market is volatile near the end of the investing time frame, you will need a lot of additional funds. This may catch investors unprepared for this additional savings requirement.
  • Value averaging most often provides a lower average cost per share than does DCA, and also provides for a higher internal rate of return (IRR). This does not, however, mean that value averaging will result in a higher realized profit. [4]

See also

References

  1. Bruce Ramsey, The Value Averaging Investment Strategy
  2. Michael E. Edelson Value Averaging; ISBN 978-0470049778
  3. Source: Sigma Investing:Value Averaging
  4. For bias in return measurement, see Hayley, Simon, Value Averaging and the Automated Bias of Performance Measures (March 11, 2011). Available at SSRN: http://ssrn.com/abstract=1606347

External links

Bibliography