Value Averaging

Value averaging is an investment strategy within the broader field of investment strategy that seeks to achieve a predetermined growth path for an investment portfolio over time. Unlike methods that involve investing a fixed amount of money at regular intervals, value averaging adjusts the amount invested or withdrawn based on the portfolio's actual performance relative to its target value. This dynamic approach aims to achieve more consistent returns and can be particularly beneficial in managing market volatility by prompting investors to buy more shares when prices are lower and fewer, or even sell, when prices are higher, aligning with specific financial goals.

History and Origin

Value averaging was developed by Michael Edleson, a former finance professor at Harvard Business School, who first introduced the concept in an article in 1988 and later detailed it in his 1993 book, "Value Averaging: The Safe and Easy Strategy for Higher Investment Returns." Edleson's work proposed a systematic method for individuals to manage their investment contributions, aiming to make the value of their holdings grow by a fixed amount over regular periods. The strategy builds on existing principles of systematic investing and portfolio rebalancing, combining them to create a disciplined approach for the accumulation phase of an investor's journey. Discussions and explanations of value averaging, including its historical context and mechanics, are widely available in investment communities.⁸

Key Takeaways

• Value averaging is an investment strategy that targets a specific increase in portfolio value over set periods.
• It requires adjusting contribution amounts based on actual portfolio performance; more is invested if the portfolio underperforms its target, and less (or even a withdrawal) if it overperforms.
• The method inherently encourages buying low and selling high, a principle often sought by investors.
• Value averaging aims for a smoother, more predictable growth trajectory for a portfolio over time, rather than fixed periodic contributions.
• It generally involves more active management and potentially larger cash reserves than simpler strategies.

Formula and Calculation

The core principle of value averaging involves calculating the amount needed to bring the portfolio's value to a predetermined target at each interval.

The target value for period (t) can be defined as:

$V_t = V_{t-1} + T$

Where:

• (V_t) = Target portfolio value at the end of period (t)
• (V_{t-1}) = Actual portfolio value at the end of period (t-1)
• (T) = The predetermined target increase in portfolio value for each period

The amount to invest (or withdraw) in period (t), denoted as (I_t), is then calculated as:

$I_t = V_t - A_t$

Where:

• (I_t) = Investment amount in period (t) (positive for investment, negative for withdrawal)
• (A_t) = Actual portfolio value at the beginning of period (t) (which is (V_{t-1}) plus any market gains/losses during period (t-1))

This calculation ensures that the actual portfolio value aligns with the desired growth path.

Interpreting the Value Averaging Strategy

Interpreting value averaging involves understanding its dynamic nature. Instead of simply putting in a fixed sum, an investor using value averaging constantly evaluates whether their portfolio is ahead or behind its planned growth trajectory. If the market performs well, and the portfolio value exceeds the target, the investor contributes less, or might even make a withdrawal. Conversely, if the market declines or the portfolio underperforms its target, the investor is prompted to contribute more capital. This mechanism is designed to take advantage of market fluctuations, essentially buying more when prices are low and less when they are high, which is a key component of prudent asset allocation. The interpretation hinges on the idea that the "value" of the investment, not just the number of shares bought, should follow a consistent upward path.

Hypothetical Example

Consider an investor, Alex, who decides to implement value averaging with a goal of increasing their equities portfolio value by $1,000 each month. Alex starts with an initial investment of $5,000.

• Month 1:
  • Target Value: $5,000 (initial) + $1,000 = $6,000.
  • Alex invests $1,000. Actual portfolio value: $6,000.
• Month 2:
  • Market experiences a slight downturn. Alex's $6,000 portfolio drops to $5,800.
  • Target Value: $6,000 (previous target) + $1,000 = $7,000.
  • Amount to invest: $7,000 (target) - $5,800 (actual) = $1,200.
  • Alex invests $1,200. Actual portfolio value: $5,800 + $1,200 = $7,000.
• Month 3:
  • Market rebounds strongly. Alex's $7,000 portfolio grows to $7,500.
  • Target Value: $7,000 (previous target) + $1,000 = $8,000.
  • Amount to invest: $8,000 (target) - $7,500 (actual) = $500.
  • Alex invests $500. Actual portfolio value: $7,500 + $500 = $8,000.

This example illustrates how the investment amount fluctuates each month to ensure the portfolio reaches its predetermined value target.

Practical Applications

Value averaging finds practical application among investors seeking a disciplined approach to building wealth, particularly during the accumulation phase. It can be applied to various investment vehicles, including individual equities, mutual funds, and exchange-traded funds (ETFs). By requiring larger contributions during market dips and smaller ones (or even sales) during rallies, value averaging inherently enforces a "buy low, sell high" discipline.⁷ This strategy can be especially appealing for investors with irregular income streams or those who want to exert more control over their portfolio's growth path than a simple systematic investing plan might offer. It helps investors align their contributions with their financial goals by ensuring their portfolio's value progresses along a pre-defined path.

Limitations and Criticisms

While value averaging offers potential benefits, it also comes with limitations and criticisms. One significant drawback is the potential for highly variable contribution amounts, which can be challenging for investors with fixed incomes or limited emergency funds. In a rapidly rising market, the strategy might require little to no new contributions, or even withdrawals, to maintain the target value. Conversely, a prolonged bear market or significant market volatility could necessitate very large contributions, potentially exceeding an investor's capacity or risk tolerance.⁶

Academic research has also offered critiques, particularly concerning the measurement of returns and the implied assumption of available capital for large investments during downturns. Some studies suggest that while value averaging may appear to generate higher internal rates of return in certain scenarios, this can be misleading due to the timing of cash flows, as the strategy invests more after poor returns.⁵ Additionally, the need for more active management and potentially maintaining a significant "side fund" of cash to meet large investment requirements can be a practical hurdle. The strategy's effectiveness compared to others also depends on market conditions and the chosen investment horizon.⁴ Critics also point out that behavioral finance aspects, such as the psychological difficulty of investing large sums into a falling market, can make adhering to value averaging challenging for many individuals.

Value Averaging vs. Dollar-Cost Averaging

Value averaging and dollar-cost averaging are both systematic investment strategies, but their fundamental mechanics and goals differ significantly.

While dollar-cost averaging focuses on consistently investing a set amount regardless of market conditions, leading to purchasing more shares when prices are low and fewer when high, value averaging focuses on the value of the portfolio, prompting larger investments when the portfolio falls short of its target and smaller ones (or even sales) when it exceeds it.³ This makes value averaging a more dynamic and potentially more aggressive strategy in certain market environments.² The Wall Street Journal has explored the effectiveness of dollar-cost averaging, often contrasting it with strategies like value averaging that respond to market fluctuations differently.¹

FAQs

1. Is value averaging suitable for all investors?

Value averaging may not be suitable for all investors. It requires a greater understanding of market dynamics and a disciplined approach, as it necessitates variable contributions and potentially even withdrawals from the portfolio. Investors with a lower risk tolerance or those who prefer simpler, set contributions might find other strategies more appealing.

2. Does value averaging guarantee higher returns?

No, value averaging does not guarantee higher returns. Like any investment strategy, its performance is subject to market conditions and the inherent risks of investing. While some studies suggest it can lead to higher returns in certain volatile market scenarios, others caution that the perceived advantage can be an artifact of how internal rates of return are calculated.

3. Can I use value averaging with my 401(k) or IRA?

Implementing value averaging directly within a 401(k) or IRA can be challenging due to administrative limitations. These accounts typically facilitate fixed, recurring contributions. However, an investor could approximate value averaging by manually adjusting their contribution percentages or making lump-sum adjustments within the limits of the plan and IRS rules, possibly by shifting funds between different mutual funds or ETFs within the plan, if allowed.

4. What is the main benefit of value averaging?

The main benefit of value averaging is its systematic enforcement of "buy low, sell high." By committing to a predetermined value path for the portfolio, the strategy compels the investor to invest more when the market is down and the portfolio value is below target, and less when the market is up and the portfolio value is above target. This systematic adjustment aims to achieve more consistent growth towards specific financial goals and can potentially improve overall returns through effective market timing.

5. How does compounding affect value averaging?

Compounding is a fundamental principle in investing where earnings generate further earnings over time. Value averaging takes advantage of compounding, as the growing target value for the portfolio implicitly accounts for expected returns from the existing investment. If the actual compounding outpaces the target, the investor contributes less; if it falls short, more is added to get back on track. This interaction ensures the strategy continually works towards a desired wealth accumulation path, leveraging the power of compounding.