Value Averaging
A disciplined investment approach that systematically buys more when prices are low and less when prices are high
Strategy Type
Wealth Preservation
Risk Level
Low to Moderate
Time Horizon
Long-Term (5+ years)
Ideal For
Disciplined Investors
What is Value Averaging?
Value Averaging (VA) is a sophisticated investment strategy that builds upon the principles of Dollar-Cost Averaging (DCA) but adds a mathematical component that adjusts your investment amount based on market performance. While DCA involves investing a fixed amount at regular intervals, Value Averaging focuses on growing your portfolio by a fixed amount each period.
With Value Averaging, you establish a target growth rate for your portfolio and adjust your contributions to meet that target. When your investments underperform, you invest more to catch up to your target; when they outperform, you invest less or potentially even sell some assets. This disciplined approach systematically enforces the investment principle of "buy low, sell high."
Key Benefits
- Enhanced Buy-Low, Sell-High Discipline: Automatically invests more when prices are low and less when prices are high, potentially improving returns compared to Dollar-Cost Averaging.
- Reduced Emotional Decision-Making: Provides a mathematical framework that removes emotion from the investment process.
- Predictable Portfolio Growth: Creates a more predictable growth trajectory for your portfolio over time.
- Potentially Lower Average Cost: Studies suggest Value Averaging can result in a lower average cost per share compared to Dollar-Cost Averaging over long periods.
- Adjusts to Market Conditions: Automatically adapts your investment amount based on recent market performance.
How Value Averaging Works
To understand Value Averaging, let's compare it with Dollar-Cost Averaging using a practical example:
Example: Value Averaging vs. Dollar-Cost Averaging
Imagine you want to invest in an index fund with the following parameters:
- Initial investment: $500
- Monthly target growth: $500 (for Value Averaging)
- Monthly fixed investment: $500 (for Dollar-Cost Averaging)
- Investment period: 6 months
| Month | Share Price | DCA Investment | DCA Shares | VA Target Value | VA Investment | VA Shares |
|---|---|---|---|---|---|---|
| 1 | $50.00 | $500 | 10.00 | $500 | $500 | 10.00 |
| 2 | $45.00 | $500 | 11.11 | $1,000 | $550 | 12.22 |
| 3 | $40.00 | $500 | 12.50 | $1,500 | $600 | 15.00 |
| 4 | $48.00 | $500 | 10.42 | $2,000 | $680 | 14.17 |
| 5 | $55.00 | $500 | 9.09 | $2,500 | $575 | 10.45 |
| 6 | $60.00 | $500 | 8.33 | $3,000 | $500 | 8.33 |
| Total | $3,000 | 61.45 shares | $3,000 target | $3,405 | 70.17 shares | |
Results Analysis:
- Dollar-Cost Averaging: Invested a total of $3,000, acquiring 61.45 shares at an average cost of $48.82 per share.
- Value Averaging: Invested a total of $3,405, acquiring 70.17 shares at an average cost of $48.53 per share.
- Final Portfolio Value (at $60 per share):
- DCA: $3,687 (61.45 shares × $60)
- VA: $4,210 (70.17 shares × $60)
In this example, Value Averaging outperformed Dollar-Cost Averaging by acquiring more shares at a lower average cost. The strategy invested more aggressively when prices dropped in months 2 and 3, and less aggressively when prices rose in months 5 and 6.
Note that Value Averaging required a higher total investment ($3,405 vs. $3,000) in this scenario because the market ended higher than it started. In a declining market, Value Averaging would typically require less capital than Dollar-Cost Averaging.
The Mathematics Behind Value Averaging
Value Averaging follows a simple mathematical formula to determine how much to invest each period:
The Value Averaging Formula
Investment Amount = Target Portfolio Value - Current Portfolio Value
Where:
- Target Portfolio Value = Starting Value + (Growth Amount × Number of Periods)
- Current Portfolio Value = The actual current value of your investments
If the result is positive, you invest that amount. If it's negative, you theoretically should sell that amount (though many investors modify the strategy to avoid selling, as we'll discuss later).
This formula ensures that your portfolio grows by your target amount each period, regardless of market performance. When markets underperform, you invest more to make up the difference; when markets outperform, you invest less to avoid exceeding your target.
Value Averaging vs. Dollar-Cost Averaging
While both strategies are systematic approaches to investing that help reduce the impact of market volatility, they have important differences:
| Feature | Dollar-Cost Averaging | Value Averaging |
|---|---|---|
| Investment Amount | Fixed amount each period | Variable amount based on portfolio performance |
| Mathematical Approach | Simple and straightforward | More complex, requires calculations each period |
| Cash Flow Requirements | Predictable and consistent | Unpredictable, may require larger investments during downturns |
| Potential Returns | Good, especially compared to lump sum in volatile markets | Potentially better than DCA in most market conditions |
| Implementation Complexity | Very easy to implement | Moderately complex, requires regular calculations |
| Selling Requirements | Never requires selling | May require selling in strongly rising markets |
Key Insights:
- Value Averaging typically outperforms Dollar-Cost Averaging in theoretical studies, but the difference may be reduced in real-world implementations due to taxes, transaction costs, and modifications to avoid selling.
- Value Averaging requires more active management and calculation, making it less "set it and forget it" than Dollar-Cost Averaging.
- The unpredictable cash flow requirements of Value Averaging can be challenging for some investors, particularly during market downturns when larger investments may be required.
- Both strategies are superior to emotional, reactive investing and help enforce disciplined investing habits.
Implementing Value Averaging
Step-by-Step Guide
- Determine your target growth rate: Decide how much you want your portfolio to grow each period (monthly, quarterly, etc.). This should be realistic based on your financial capacity.
- Make your initial investment: Start with an initial investment that matches your first period's target.
- Calculate subsequent investments: At the beginning of each new period:
- Calculate your target portfolio value: Initial investment + (Target growth × Number of periods)
- Determine your current portfolio value
- Calculate the required investment: Target value - Current value
- Execute your investment: Invest the calculated amount, which may be more or less than your target growth rate depending on market performance.
- Maintain a cash reserve: Keep sufficient cash available to make larger investments during market downturns.
- Review and adjust periodically: Annually review your target growth rate and adjust if necessary based on changes in your financial situation.
Pro Tips:
- Consider using a spreadsheet to automate calculations and track your progress.
- Modify the strategy to establish a minimum investment amount (never going below zero) to avoid having to sell investments.
- Use Value Averaging for tax-advantaged accounts to avoid tax implications when the strategy calls for selling.
- Combine Value Averaging with broad-based index funds or ETFs to minimize transaction costs and simplify implementation.
- Maintain a larger emergency fund when using Value Averaging to ensure you can meet potentially larger investment requirements during market downturns.
Common Challenges and Solutions
Challenge: Cash Flow Variability
Problem: Value Averaging may require significantly larger investments during market downturns, which can strain your finances.
Solution: Maintain a dedicated cash reserve specifically for your Value Averaging strategy, separate from your emergency fund. Alternatively, set a maximum investment limit per period based on your financial capacity.
Challenge: Selling Requirements
Problem: The strategy may call for selling investments during strong bull markets, which can trigger tax consequences and may feel counterintuitive.
Solution: Many investors modify Value Averaging to establish a minimum investment of zero, never selling but instead investing less or nothing during strong markets. This modification may reduce theoretical performance but simplifies implementation.
Challenge: Calculation Complexity
Problem: Value Averaging requires more complex calculations than Dollar-Cost Averaging, which can be a barrier to consistent implementation.
Solution: Use a spreadsheet template or investment app that automates the calculations. Set calendar reminders to ensure you perform the calculations at the appropriate intervals.
Who Should Use Value Averaging?
Value Averaging is particularly well-suited for:
- Mathematically-inclined investors who appreciate the logical structure of the strategy
- Disciplined investors with sufficient financial flexibility to handle variable investment amounts
- Investors with a long-term horizon who can ride out market volatility
- Those who have the capacity to maintain a cash reserve for larger investments during downturns
- Investors using tax-advantaged accounts where the potential need to sell doesn't trigger tax consequences
Variations and Modifications
Modified Value Averaging (No Selling)
This common modification establishes a minimum investment of zero, eliminating the need to sell investments when the formula would otherwise call for it. While this may reduce theoretical performance, it simplifies implementation and avoids tax consequences.
Capped Value Averaging
This variation sets both a minimum and maximum investment amount per period, addressing the cash flow variability challenge. While this limits the strategy's ability to fully capitalize on market downturns, it makes implementation more practical for most investors.
Hybrid Approach
Some investors combine Value Averaging with Dollar-Cost Averaging by establishing a base investment amount (DCA component) plus an adjustment based on portfolio performance (VA component). This approach provides more predictable cash flow requirements while still capturing some of the benefits of Value Averaging.