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)
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.
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.
FAQs
Is value averaging suitable for all investors?
While value averaging can lead to higher returns than DCA, it’s best suited for disciplined investors who can manage the complexities and potential tax implications.
Can value averaging be automated?
Some modern brokerage platforms offer automation for strategies akin to value averaging, though it may require custom financial software or advisors.