Value Averaging

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Value Averaging is a formula-based strategy for making periodic investments. It was developed in 1988 by Michael Edleson and is described in his book, Value Averaging: The Safe and Easy Strategy for Higher Investment Returns. The basic idea is to invest an amount of money so that the value of your holdings will meet a pre-determined target value in each period. In order to meet this target, in some periods you may actually need to sell some of your holdings. Thus, Value Averaging will help force investors to buy low and sell high. The Value Averaging technique is driven by formulae which will determine the target value of your holdings for each period of your investment horizon based on information provided by the investor (including final target value and expected rate of growth of your investment). This method has been shown to produce higher investor internal rates of return (IRRs) than the most common formula-based investment strategy, dollar cost averaging.

The most commonly used formula-based strategy is dollar cost averaging. Dollar cost averaging simply requires that the investor invest the same amount of money each period. For instance, if you have $100 available each month to invest in your retirement portfolio, you will simply buy shares worth $100. When the price of shares is low, you end up purchasing more shares. When the price of shares is high, you purchase fewer shares. Thus, dollar cost averaging helps enforce the discipline of buying more shares when price is low and buying fewer shares when price is high. It never requires you to sell shares. With dollar cost averaging, you can build in a growth in your periodic investment (if your salary is expected to increase for instance).

Mechanics of Value Averaging

Let’s discuss exactly how Value Averaging works. Value Averaging incorporates one crucial piece of information that is missing in dollar cost averaging – the expected rate of return of your investment. You must provide this information for the Value Averaging formula. Having this data allows the Value Averaging formula to “identify” periods of investment over-performance and under-performance. After the investment has over-performed, you will be required to buy less or sell (selling high). After the investment has under-performed, you will be required to buy more (buying low).

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.

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 Excel 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.

Advanced Ideas

Value Averaging allows you to be conservative when attempting to reach an investment goal in several ways. You could put in conservative figures for the expected rate of growth of the investment. Alternatively, you could require that you meet the target goal in fewer periods than you actually require. Both of these techniques can help guard against the negative impacts of a large drop in investment value when you get very close to your final period.

You should also consider the tax consequences of following the Value Path exactly. The Value Path may require sales of assets which may trigger tax consequences. To avoid these taxes, you can change the implementation so that you only sell shares after 2 or 3 consecutive periods of sale requirements from the Value Averaging formula. Being more extreme, you could just ignore all sale requirements from the Value Path. This can also help you to reduce transaction costs.

Performance

In his book, Edleson provides ample evidence that the Value Averaging strategy will provide greater internal rates of return on the money invested than dollar cost averaging. He uses both historical data and simulations to show these results. It appears that Value Averaging will provide about a 1% boost to your IRR. It doesn’t over-perform in all periods but seems to be better in the vast majority of instances. The results are pretty convincing.

One thing to note is that Edleson is using IRRs to compare the strategies. The IRR is a very useful measure of the effectiveness of an investment strategy. However, it is not perfect. One problem with IRRs is that they don’t take into account the amount of capital invested. For example, if your investment performs really well, then the Value Averaging approach may require you to contribute less capital than the dollar cost averaging approach. In reality, the unused cash that was allocated for contributions to the investment will probably be kept in a safer vehicle like a money market account and earn interest. This interest rate may be substantially worse than the rate of return of the investment asset. There is a reasonable chance that the dollar cost averaging approach will result in a larger final position. So, while its IRR is worse, the dollar cost averaging approach will actually create more wealth.

A better analysis may be to assume that the Value Averaging investor will use a money market account to hold unused planned contributions and must borrow at a certain interest rate if he needs there is a shortfall in his available funds. The final position of the Value Averaging investor will simply be the value of his investment plus the amount in the money market account minus any outstanding loans. Then, you could compare the final positions of both strategies. This is more complicated but would be a more fair comparison.

In conclusion, the Value Averaging approach is definitely a valuable weapon to keep in the serious investor’s arsenal. If you have a specific target and good knowledge of expected returns, this technique can definitely help boost your returns. We would encourage investors to read Edleson’s book to become more familiar with the concept.

Resources

Wiley, the publisher of Edleson’s book, has made some of his Excel worksheets available for download.