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 orportfolio valuefalls 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.
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.
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 theVA strategyis 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 whendrawdownin the account could require substantially larger amounts of capital to stick with the VA strategy.
An investor has decided to invest in XYZ stock for an extended period of time in order to build wealth. This year, he has 1200 rupees to invest. So, rather than investing 100 rupees every month, he waits for a stock decline and then invests heavily.
Value averaging aims to invest more when the share price falls and less when the share price rises. Instead of investing a set amount each period, a value averaging strategy makes investments based on the total size of the portfolio at each point.
For instance, instead of investing $1,000 in Tesla at one time, someone using dollar-cost averaging might invest $50 in Tesla at the same time every week for 20 weeks.
Dollar cost averaging helps investors become accustomed to fluctuations. “You're putting a regular amount to work in the market over time without regard to price,” says Haworth. “Sometimes prices will be higher, sometimes they'll be lower, but you essentially continue to accumulate investments.”
It is carried out by acquiring more shares after there is a fall in the share price following its initial purchase. Buying more shares means the average cost of all shares held is lowered, and this leads to the breakeven point lowering as well.
The main advantage of averaging down is that an investor can bring down the average cost of a stock holding substantially. Assuming the stock turns around, this ensures a lower breakeven point for the stock position and higher gains in dollar terms (compared to the gains if the position was not averaged down).
VA does better averaging than Dollar-Cost Averaging by pumping in more money to work in a downward market and reducing investment when the market goes up. However, VA is not well suited for indisciplined investors. There can be periods which require no investment and the investors may splurge the surplus money.
The Time Average algorithm calculates a time-weighted average of the values in a sample. Unlike the Average algorithm which simply divides the sum of the values in the sample by the number of values, the Time Average algorithm takes into account the amount of time between value changes.
The investor or trader still likes the stock and, therefore, decides to buy another 100 shares at a lower price. Use the average down stock formula below to calculate the new breakeven price: [(# of shares x purchase price) + (# of shares x second purchase price)] / total # of shares.
Dollar cost averaging is the practice of investing a fixed dollar amount on a regular basis, regardless of the share price. It's a good way to develop a disciplined investing habit, be more efficient in how you invest and potentially lower your stress level—as well as your costs.
Imagine an employee who earns $3,000 each month and contributes 10 percent of that to their 401(k) plan, choosing to invest in an S&P 500 index fund. Because the price of the fund moves around, the number of shares purchased isn't always the same, but each month $300 is invested.
The strategy couldn't be simpler. Invest the same amount of money in the same stock or mutual fund at regular intervals, say monthly. Ignore the fluctuations in the price of your investment. Whether it's up or down, you're putting the same amount of money into it.
You Could Miss Out on Certain Opportunities. Investing in the same stock or fund every month could cause you to miss out on other investment opportunities. ...
The advantage of dollar-cost averaging: by investing in smaller set amounts over time, you'll buy both when prices are low and high. This smoothes out your average purchase price. Dollar-cost averaging can be especially powerful in recessions and bear markets.
Research by Vanguard has found that lump-sum investing outperforms dollar-cost averaging 68% of the time. Dollar-cost averaging is the lower-risk option, and it's a good long-term investing strategy.
You might be interested in buying XYZ stock but don't want to take the risk of investing your money all at once. Instead, you could invest a steady amount, say $300, every month. If the stock trades at $10 in a given month, you will buy 30 shares.
Most investors prefer the monthly dollar cost averaging method. This is a more familiar frequency to those used to a SIPP plan where funds are taken directly from your salary and invested into your investment account.
Introduction: My name is Kerri Lueilwitz, I am a courageous, gentle, quaint, thankful, outstanding, brave, vast person who loves writing and wants to share my knowledge and understanding with you.
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