Value Averaging

What Is Value Averaging?

Value averaging (VA) is an investing strategy that works like dollar-cost averaging (DCA) in terms of making steady monthly contributions but differs in its approach to the amount of each monthly contribution. In value averaging, the investor sets a target growth rate or an amount of their asset base or portfolio each month and then adjusts the next month's contribution according to the relative gain or shortfall made on the original asset base.

Therefore, instead of investing a set amount each period, a VA strategy makes investments based on the total size of the 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, one 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 main goal of value averaging (VA) is to acquire more shares when prices are falling and fewer shares when prices are rising. This is what happens in dollar-cost averaging as well, but the effect is less pronounced. Several independent studies have shown that over multiyear periods, value averaging can produce slightly superior returns to dollar-cost averaging, although both will closely resemble market returns over the same period.

In dollar-cost averaging (DCA), investors always make the same periodic investment. The only reason they buy more shares when prices are lower is that the shares cost less. In contrast, using value averaging, investors buy more shares because prices are lower, and the strategy ensures that the bulk of investments is spent on acquiring shares at lower prices.

The reason value averaging may be more or less attractive to an investor than using a set contribution schedule is that you are somewhat protected from overpaying for stock when the market is hot. If you avoid overpaying, your long-term returns will be stronger compared to people who invested set amounts no matter the market condition.

DCA vs. Value Averaging
DCA vs. Value Averaging.

Image by Sabrina Jiang © Investopedia 2020

Example of Value Averaging

For the example above, suppose the goal is for the portfolio to increase by $1,000 every quarter. If in a quarter's time, the assets have grown to $1,250 (based on the 100 shares in Q1 multiplied by Q2 price of $12.50), the investor will fund the account with $750 ($2,000 - $1250) worth of assets. Q2 purchase of $750 divided by a share price of $12.50 will buy 60 additional shares, bringing the total to 160 shares. 160 shares x $12.50=$2,000 value for Q2. 

In the following quarter, the goal would be to have account holdings of $3,000. This pattern continues to be repeated in the following quarter, and so on.

While there are performance differences between value averaging, dollar-cost averaging, and set investment contributions, each is a good strategy for disciplined long-term investment—particularly for retirement.

Challenges to Value Averaging

The biggest potential challenge with value averaging is that as an investor's asset base grows, the ability to fund shortfalls can become too large to keep up with. This is especially noteworthy in retirement plans, where an investor might not even have the potential to fund a shortfall given limits on annual contributions.

One way around this problem is to allocate a portion of assets to a fixed-income fund or funds, then rotate money in and out of equity holdings as dictated by the monthly targeted return. This way, instead of allocating cash in the form of new funding, cash can be raised in the fixed income portion and allocated in higher amounts to equity holdings as needed.

Another potential problem with the VA strategy is that in a down market an investor might actually run out of money, making the larger required investments impossible before things turn around. This problem can be amplified after the portfolio has grown larger when drawdown in the account could require substantially larger amounts of capital to stick with the VA strategy.

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