Value Averaging Method of Investment
There are many investors who believed that dollar-cost averaging was not a good strategy and that it did not work well in the long run. However, they liked the averaging part of the strategy. This meant that they wanted a systematic plan to make investments at regular intervals. Also, they wanted to adjust their investments based on the market sentiment. This meant that they wanted to buy low and sell high. This is the reason why they came up with another investment strategy called value averaging.
Value averaging is considered to be similar to dollar-cost averaging. This is the reason why many investors often compare the results of the two strategies to find out which would be the better option. Many times investors get confused between the strategies thinking that its the same. In this article, we will explain the concept of value averaging in greater detail.
What is Value Averaging?
The value averaging method of investment is more complicated as compared to the dollar-cost averaging method of investment. This is because, in dollar-cost averaging, the instructions are simple. The investor needs to invest a fixed sum of money every month. However, when it comes to the value averaging, the instructions can be complicated to follow.
In order to do value investing, one has to first create a value path. This means that the investor must have a monthly or quarterly target about where they want their investment to be. Suppose a person wants their portfolio value to be $1000 over a 10 month period. From this value, the investor derives what the monthly targets are. For instance, the investor may want their portfolio value to be $100, $200, and $300 in the first, second, and third months respectively.
Lets say that they invest $100 in the first month. By the end of the first month, the $100 grows to $110. Hence, now the investor only needs to add $90 to meet their target of $200. In the next month, the market witnesses a drop, and the value of the portfolio drops to $175.
In this situation, the investor will have to invest $125 instead of $100 in order to meet their monthly target of $300. Hence, the amount which is to be invested in the next month is based on the performance of the portfolio in the previous month.
Value averaging may be unique in the sense that it also advises people to withdraw money from the portfolio. For instance, if, in the above-mentioned case, the target for the fourth month was $400 and the portfolio value reached $420 at the beginning of the month, the investor would be advised to remove $20 in order to meet the target of $400.
The Argument in Favour of Value Averaging
Value averaging, just like dollar-cost averaging, builds a financial discipline in the investors. Also, it encourages investors to follow a disciplined and somewhat mechanical approach to investing instead of being misled by their emotions of greed and fear.
Proponents of value averaging believe it to be more effective. This is because the target system of investing makes sure that investors contribute very little money when the market is increasing by leaps and bounds and hence could possibly be in a bubble stage.
According to the proponents of this strategy, by varying the amounts based on certain rules, the volatility of the market can be avoided. The above-mentioned reasons are why some proponents claim that the returns provided by value averaging are greater than the ones provided by dollar-cost averaging. The validity of this claim is widely debated all over the world.
The Arguments against Value Averaging
Some critics consider dollar-cost averaging to be complex. Hence, for them, value averaging is extremely complex. The calculation of the value path is not easy. There are several assumptions made in the process. For instance, it is assumed that the investor is aware of the desired value of their final portfolio.
It is also assumed that the investor is able to estimate the effects of inflation to determine the desired growth rate and finally draw a reasonable value path. The reality is that factors affecting growth rate keep on changing from year to year. Hence, the value path may not be stable and may have to change. Also, if the value path itself is incorrect, then all decisions based on its comparison with the portfolio value will also be incorrect.
Another common criticism is that the value averaging method assumes that people always have some spare cash lying around. This is because in periods when markets go down, it recommends increasing the investment.
The reality is that markets tend to go down in periods of recessions and depressions. That is also the time when the incomes of people are also going down. Hence, the value averaging method may be hard to implement. Also, if the investor just has a stash of cash lying around to infuse in the market, this means that they are not fully invested. This also means that their returns will be suboptimal since a part of their portfolio is earning very low returns.
The bottom line is that value averaging is a sophisticated strategy. The execution of dollar-cost averaging can be done by a layman. However, the same cannot be said for value averaging. Also, the returns provided by this strategy are disputed. This is the reason that value averaging is not as famous as dollar-cost averaging. However, it is still used by a large number of people in order to manage their personal finances.
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The article is Written By Prachi Juneja and Reviewed By Management Study Guide Content Team. MSG Content Team comprises experienced Faculty Member, Professionals and Subject Matter Experts. We are a ISO 2001:2015 Certified Education Provider. To Know more, click on About Us. The use of this material is free for learning and education purpose. Please reference authorship of content used, including link(s) to ManagementStudyGuide.com and the content page url.
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