Value averaging (VA) is an investing strategy that works similarly to dollar-cost averaging (DCA) by involving steady monthly contributions. However, it differs in the approach to the amount of each contribution. In value averaging, the investor sets a target growth rate or predetermined portfolio value for each month and acutely adjusts the next month’s contribution according to the asset base’s relative gain or shortfall.
In essence, unlike investing a fixed amount each period, a VA strategy tailors investment sizes based on the portfolio’s total value at each interval.
Key Takeaways
- Value averaging is an investment strategy that comprises regular contributions to a portfolio over time.
- One invests more when the price or portfolio value falls and less when it rises in the value averaging technique.
- This strategy entails calculating the future periods’ targeted total investment value, then making investments sized to match these targets.
Grasping Value Averaging
The objective of value averaging (VA) is to amass more shares as prices drop and fewer shares as prices climb, coupling with the principles of dollar-cost averaging, though more pronounced. Independent studies affirm that over multiyear spans, value averaging can yield slightly superior returns compared to dollar-cost averaging, even though both align closely with market returns during similar periods.
In dollar-cost averaging (DCA), investors make uniform periodic investments. They buy more shares solely because of lower share costs during dips. Contrarily, value averaging allows investors to make larger share purchases in lower-price environments, deploying more substantial portions of investments at favorable rates.
Value averaging may attract investors more than set contribution schedules as it safeguards against investing excessively when the market is hot. This avoidance of overpayments magnifies long-term returns compared to fixed-amount investments regardless of market conditions.
Illustrative Example of Value Averaging
Suppose a portfolio is aimed to augment by $1,000 every quarter. At a quarter’s end, if the assets are valued at $1,250 (100 shares from Q1 multiplied by a Q2 price of $12.50), the investor contributes $750 ($2,000 - $1,250) for the assets. Q2 purchase, featuring $750 divided by $12.50 share price, results in 60 additional shares—totaling 160 shares equating a $2,000 value for Q2.
Following this pattern, the goal for the subsequent quarter would be $3,000 in holdings. This recursive method not only captures investment returns but aligns drawdowns with a proven strategy.
Challenges to Value Averaging
Substantial growth in an investor’s asset base can challenge the feasibility of funding shortfalls, notably emphasized in retirement plans where annual contribution limits limit fulfilling required shortfalls.
One mitigation strategy is to allocate part of the assets into a fixed-income fund, thereby rotating sums between equity holdings and retain targeted monthly returns. Instead of new funding, cash reallocation in fixed income translates to equity holdings when warranted.
A downside envisage is in slump markets where the investor may exhaust available funds, complicating larger required investments unless markets pivot. This pitfall becomes pronounced in massive portfolios when drawdowns necessitate significantly increased capital for maintaining the VA strategy.
Related Terms: Dollar-Cost Averaging, Investment Strategy, Fixed-Income Funds, Market Conditions.
