Value averaging has been touted as an investment strategy that produces higher returns than dollar-cost averaging, but the evidence for this so-called smarter strategy doesn’t seem to stack up. The two strategies, which are often compared to and occasionally confused with one another, share some similarities but also significant differences.
Most investors are familiar with dollar-cost averaging, whereby you invest a fixed amount regularly. Because the dollar amount you invest remains the same, you automatically buy more shares when the price is low and fewer shares when the price is high, reducing your average share price.
With value averaging, however, the amount you invest varies. You begin by determining a value you want your portfolio to reach in a certain period, for example, $10,000 in 10 years. You then work backward to determine how much your portfolio needs to grow each period to reach your end goal. This is called your “value path.” Your value path can be defined by a percentage growth or a dollar value over any length of time you wish.
Let’s say you determine your portfolio must grow $1,000 each year to reach your goal. At the start of your first year, you invest $1,000. Suppose the markets do well and you end the year at $1,300. According to your value path, your portfolio should be worth $2,000 at this point. So, instead of investing $1,000 at the start of your second year, you invest only $700, or the amount needed to bring your portfolio in line with your value path. Alternatively, if the portfolio’s value fell to $800 in your first year, you would have needed to invest $1,200 the second year.
[See: 10 Long-Term Investing Strategies That Work.]
In this way, value averaging guides investors to “add more in markets that have declined and add less — or even subtract — in markets that have run up,” says S. Michael Sury, a finance lecturer at the University of Texas at Austin.
The value of value averaging. This prompt to sell is unique to value averaging. Because you may have to pull money out if the market climbs above your value path, value averaging could “reduce your risk better than dollar-cost averaging over a long period of time,” says Joel V. Russo, president of Premier Financial Group in Wall, New Jersey.
Value averaging also delivers on its promise to “intelligently smooth” investment volatility, Sury says. By following a value path, investors create a portfolio that increases in value steadily, whether the market goes up or not. Instead of depending on the whims of the stock market, investors control their portfolio’s growth by systematically adding just enough to meet their long-term goals.
The linchpin is that you must have a final goal in mind, an essential part of any investing strategy. But critics contend value averaging has more flaws than benefits, and the portfolio’s steady upward trajectory, though reassuring, doesn’t jack up returns.
It’s complicated. In fact, the strategy involves more work with no added payoff. “Value averaging results in unpredictable cash flows,” says Simon Hayley, a senior finance lecturer at Cass Business School in London. You can’t know how much you will need to invest at the end of each period until you get there and have calculated how much to add. “You must be more hands-on with value averaging than dollar-cost averaging, which you just set and basically forget,” Russo says.
[See: 9 Investing Steps From Warren Buffett’s Playbook.]
It encourages bad habits. Value averaging requires “an investor to maintain a side cash balance from which to make periodic investments,” Sury says. “This creates a situation where an investor is nearly always less than fully invested.”
It doesn’t boost returns. “Putting up with these disadvantages could be entirely worthwhile if value averaging really did boost your returns,” Hayley says, but it probably won’t. What it does boost is your dollar-weighted return, which is a misleading indicator of how well your portfolio is performing, he says.
With a dollar-weighted return, each period’s return is given a weight proportional to the portfolio’s balance at the start of that period. An investment period which begins with $100 invested would have a greater weight than one that begins with only $75. This makes intuitive sense: More money invested means the percentage return over that period affects your portfolio more — unless you’re fooling yourself, Hayley says, which value averaging inadvertently does.
Let’s say you expect market returns of 10 percent on average each year, but in the first year, the market performs better than average and you earn 20 percent. By keeping the same amount of money invested, subsequent returns are likely to drag your overall return back down toward 10 percent.
One way to counteract this would be to withdraw money after your first year. This would “make sure the dollar-weighted return puts a nice big weight on that first success,” Hayley says. “In effect, this strategy boosts your likely dollar-weighted return by ‘quitting whilst you are ahead,’ rather than by delivering a larger portfolio value when you retire.”
Hayley uses the example of a coin toss. A player trying to get heads has a 50 percent chance of success. In a game with two tosses per round, the potential outcomes are: HH, HT, TH, TT. Your success rate then is 100 percent, 50 percent, 50 percent, 0 percent, for an average of 50 percent success.
If you change the rules of the game to allow yourself to quit after your first heads — or quit while you’re ahead — on any given round, your game would look like this: H, H, TH, TT. Now your success rate is 100 percent, 100 percent, 50 percent, 0 percent. Your new average is 62.5 percent.
In the same way, value averaging also changes the rules for a below-average first-year return. You can boost the effect of higher-returning future years by investing more money after your first terrible year, increasing your overall dollar-weighted return. “But that doesn’t mean you can expect to be richer when you retire,” Hayley says. And at the end of the period, all most of us care about is our portfolio’s total value.
You’re better off going all in. If you have a lump sum to invest and are investing long term, just invest it, says Adam Waitkevich, president and founder of Coppertree in Westborough, Massachusetts. While systematic strategies such as value averaging and dollar-cost averaging can help ease the emotional tribulations of entering the market, they often complicate a simple process without promising a higher end value.
[See: 10 Ways for Investors to Buy the Market.]
“The best way to invest is to accept that markets are unpredictable, but over time, they produce returns above alternatives,” he says. “The key to success is the ability to stay the course and not to get shaken out of our long-term strategy by emotions.”
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Value Averaging: An Investing Strategy to Avoid originally appeared on usnews.com
