Value averaging (VA) is an investing strategy that, unlike dollar-cost averaging (DCA), adjusts the amount of each periodic contribution based on the portfolio’s performance. The core principle is to ensure that the portfolio value increases by a predetermined amount every period (e.g., monthly or quarterly).
How Value Averaging Works
The investor sets a target growth rate for the portfolio value, and contributions are adjusted to meet this target:
- Set Initial Target Value: The investor decides on an initial target value and a desired rate of growth. For example, $1,000 as the initial value with a monthly target growth of $200.
- Calculate Required Contributions: At the end of each period, the investor calculates the portfolio’s performance. If the portfolio has grown beyond the target, the investor contributes less or even withdraws funds. Conversely, if it has underperformed, the investor contributes more.
Example Calculation
Initial Setup:
- Initial portfolio value: $1,000
- Monthly target increase: $200
After First Month:
- Target portfolio value: $1,200
- Actual portfolio value: $1,100
- Contribution needed: $200 (target $1,200 - actual $1,100 + monthly increase $200)
After Second Month:
- Target portfolio value: $1,400
- Actual portfolio value: $1,350
- Contribution needed: $100 (target $1,400 - actual $1,350 + monthly increase $200)
Comparing Value Averaging and Dollar-Cost Averaging
Dollar-Cost Averaging
- Fixed Contributions: Investments are made at regular intervals with a fixed amount, regardless of market conditions.
- Market Agnostic: Contributions do not change based on market performance.
Value Averaging
- Variable Contributions: The amount invested varies based on the portfolio’s performance.
- Adaptive Strategy: Contributions adapt to aging market conditions, saving during highs and investing more during lows.
Historical Context
Value averaging was popularized by Michael E. Edleson in his 1993 book “Value Averaging: The Safe and Easy Strategy for Higher Investment Returns.” The approach provides a more dynamic investment method compared to static contribution strategies like DCA.
Applicability and Special Considerations
Tax Implications
Changing contributions often can result in frequent buying and selling, potentially leading to increased capital gains taxes. Investors should consider tax-efficient accounts or strategies to mitigate this.
Transaction Costs
Frequent adjustments to contributions can incur higher transaction costs, eroding returns, especially in brokerage accounts with per-trade fees.
Related Terms
- Dollar-Cost Averaging (DCA): Investing a fixed amount regularly, regardless of market conditions.
- Targeted Rebalancing: Adjusting the proportions of different assets in a portfolio to maintain a specific risk level or strategy.
- Portfolio Value: The total worth of all investments within a portfolio.
FAQs
Is value averaging suitable for all investors?
How does value averaging perform in volatile markets?
Can value averaging be automated?
References
- Edleson, Michael E. “Value Averaging: The Safe and Easy Strategy for Higher Investment Returns.” John Wiley & Sons, 1993.
- Vanguard. “Dollar-Cost Averaging vs. Lump-Sum Investing.” Vanguard Research, 2020.
Summary
Value averaging is an adaptive investment strategy designed to ensure a portfolio grows at a consistent rate by adjusting contributions based on performance. While it can offer benefits over static methods like dollar-cost averaging, it requires careful management of tax implications and transaction costs. Suitable primarily for disciplined investors, value averaging can be a potent tool in dynamic market conditions.
