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.
Consequently, a VA strategy makes investments depending on the overall size of the portfolio at each interval rather than a fixed sum each time.
Understanding Value Averaging
Acquiring more shares during declining prices and less during increasing costs is the primary objective of value averaging or VA. Although the result is less noticeable, dollar-cost averaging also does this. Although both will closely match market returns over the same time, value averaging has been demonstrated in many independent studies to yield better returns over multiyear periods than dollar-cost averaging.
Investors use dollar-cost averaging (DCA) to create consistent recurring investments. When prices are lower, people purchase more shares because they are less expensive. On the other hand, value averaging allows investors to buy more shares at a reduced price, as it guarantees that most investments are used to purchase shares at a reduced price.
Value averaging protects against overpaying for shares during a market surge, which may or may not make it more appealing to investors than using a predetermined contribution schedule. Your long-term returns will be higher if you avoid overpaying than if you invested a fixed amount, regardless of the state of the market.
An Illustration of Value Average
For the sake of this example, assume that the objective is for the portfolio to rise by $1,000 every quarter. If, after a quarter, the assets (calculated by multiplying the 100 shares from Q1 by the price of $12.50 in Q2) total $1,250, the investor will replenish the account with $750 ($2,000 minus $1250). By dividing the Q2 purchase of $750 by the share price of $12.50, an additional 60 shares will be purchased for 160. For Q2, 160 shares x $12.50 equals $2,000.
The objective would be to have $3,000 in account holdings by the next quarter. The next quarter follows suit, and so on, with this trend continuing.
Value averaging, dollar-cost averaging, and set investment contributions all work well for disciplined long-term investing, especially for retirement, despite their disparities in performance.
Difficulties with Value Average
Value averaging’s most fantastic possible drawback is that as an investor’s asset base increases, their capacity to cover deficits may become too huge to handle. This is particularly significant for retirement plans because, due to yearly contribution limits, an investor may not even be able to cover a deficit.
To get around this issue, you may put some of your assets into a fixed-income fund or funds and then use the monthly targeted return to determine when to move money into and out of your stock holdings. In this manner, funds may be raised in the fixed-income component and distributed in larger quantities to equity holdings when required rather than being provided as fresh capital.
An additional probable issue with the VA technique is that an investor may need more money during a low market, making it hard to make the more considerable necessary investments before circumstances improve. This issue may become more severe as the portfolio grows since the account’s drawdown may require much more money to maintain the VA strategy.
Conclusion
- Value averaging is a method of investing in which a portfolio gradually increases over time via consistent contributions.
- If one were to use value averaging, they would invest less when the value of their portfolio increased and more when it decreased.
- Value averaging is setting aside predefined sums for the overall investment value in future periods and then investing the same amount in each subsequent period.
