Value Averaging: Take the Blindfolds Off
Nov 7th, 2008 by Carlos
Picture by Foxtongue
A few weeks ago I stumbled onto a post over at Cash Money Life about value averaging—something I had never heard of. What is value averaging? It’s similar to dollar-cost averaging, which I’ve said before I’m a big fan of. But instead of investing a fixed amount at a given time no matter what, value averaging takes the market into account. No, this isn’t “timing the market,” it’s more like “taking into consideration what the market is doing.”
Let’s say I want to contribute fully to my Roth IRA, which means I want to invest $5,000 in one year. Instead of breaking it down into five “purchases” of an index fund of $1,000, value averaging works backwards. You want to have $5,000 invested at the end of the year so you invest the first $1,000, then wait until your next buying period. If the market goes up, you invest less. If the market goes down, you invest more. At the end of the year, you’ve invested the same $5,000 but you’ve made small changes as to when you put your money into the market. It’s classic buy low, sell high.
When you compare value averaging to dollar-cost averaging, it seems silly not to at least try it and see where it takes you. DCA is kind of like investing with a blindfold on because you’re not even giving yourself a chance to buy low. And value averaging won’t get you all stressed out the way other “market timing” (it’s such a bad word these days) schemes out there will. This one combines the discipline and long-term thinking of DCA with a twist of “considering what the market is doing.”
If you want to read more about value averaging, check out this paper from the Journal of Financial and Strategic Decisions. It goes much more into the meat of it and also provides some good examples. From the paper:
As might be expected from a technique that does outperform, the higher the price variability and the longer the investment time horizon the better. Each gives value averaging the time and the opportunity to work its “magic”.
I’m not saying this would’ve helped investors this past year (very little could’ve), but over the long term it can certainly make a difference and when the markets are choppy like they are right now it makes sense to employ any additional strategy that could help improve our returns.
Hey, every little bit counts, especially these days.
I think value averaging can work – but only so long as investors are disciplined and willing to do the associated legwork. It also works best on shorter time periods as compared to longer time frames.
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