Value averaging is an investment strategy that helps you grow your investments by meeting periodic targets. How exactly? By using a fancy formula that keeps you on something called a value path – more on that later. In a nutshell, this investment strategy pushes your focus towards periodic target growth goals.
The formula then helps you to determine how much you’ll need to invest in a given period in order to make up the difference between your goals and how well your investments have performed.
An example of value averaging
Let’s say your target growth goal is $500 each month. You’ll start by making a $500 deposit in your investment account the first day of the first month. To keep things simple, we’ll say you started this strategy in December. So on December 1st, you deposited $500 into your account. Then, on January 1st, (the first day of the second month), you’ll take a look at your investment account balance.
If on January 1st, your balance is $600, then you’ll only need to deposit $400 for that month. However, let’s say your investments performed poorly and your account balance was only $350. Then, you’d need to deposit $650.
Remember, your target growth goal remains $500 a month. So, if you deposited $500 at the beginning of month one, your balance would need to equal $1000 by the first day of month two in order to meet your goal (i.e. $500 deposit + $500 growth goal = $1000 ending balance).
In months that your investments perform well, you won’t need to deposit the full $500 because your investments helped contribute to your target goals. But in months that your investments underperform, a value averaging strategy requires you to make up the difference by depositing more funds in order to stay on your value path.
Buy low, sell high
If this seems counterintuitive, think about the saying, buy low, sell high. Value averaging is simply a more concrete, formula driven approach with this mentality in mind. When the markets do well (the “high”), you don’t invest as much – and sometimes you might even sell. But when the markets don’t do well (the “low”), you buy.
So what exactly is a value path?
If math is not your strong suit, stick with me – I promise this is the only equation you’ll have to read in this article. V is the value path. C is your periodic contribution. t is the time period (i.e. how long your money is invested for). The sum (1 + R)t represents the average expected rate of growth for both your contribution and investments, adjusted for time in the market.
How to use the formula
You can use this formula in one of two ways. If you don’t have a specific investment goal in mind, you can plug in your contribution amounts (C) and time horizon (t) to figure out what your expected total growth will be.
Or, if you do have a specific investment goal in mind, you can set the value path equation equal to that figure. For example, if your goal is to retire with $1,000,000, set V = $1,000,000. Then you’ll be able to determine how much you need to contribute and over how long of a time span to meet your goal.
Whichever way you choose to use it, we don’t recommend doing these calculations by hand. You can use an Excel spreadsheet like this one and it will do all the calculations for you instantly.
Keep in mind the value path equation makes some assumptions about the average rate of growth. The equation holds the rate of growth constant across all time periods. This is not usually the case in the real world, especially in shorter timespans. The equation also assumes that you’ll make equal contributions each period, which likely won’t be the case since market fluctuation is natural.
An alternative: dollar cost averaging
You may have also heard of another investment strategy called dollar cost averaging. Value averaging and dollar cost averaging are often compared to one another and knowing the differences may help you determine what makes the most sense for you.
Dollar cost averaging focuses on investing a set amount of funds over regular intervals of time, regardless of the state of the market. For example, if your goal is to invest $24,000 over the course of the year, you may opt to invest $2,000 on the 15th of each month. Whether the market is high or low, you stick to your investing schedule.
Since you are consistently investing with dollar cost averaging, this investment strategy provides the benefit of reducing the overall impact of volatility on your portfolio. It also helps investors from investing emotionally, attempting to time the market, and forces your focus to be on the long term.
Advantages of value averaging
The primary advantage of value averaging is that it pushes you to buy low and sell high. This strategy ultimately helps you to achieve a greater rate of growth with less risk. However, while there may be less risk to your invested funds, there are other risks associated with this investment method. These other risks, described below, are what cause value averaging to catch a lot of flack.
Disadvantages of value averaging
There are two big disadvantages to value averaging. The first is that the value path can be limiting. Sure, it’s a good thing to buy when the market is low, but is it in your best interest to only invest as much as your value path indicates? Doing so may put unnecessary limitations on your investment potential.
Secondly, because the method of value investing is not consistent (your deposits depend on how well your investments perform), it would require you to have money set aside, available for whatever the market decides to do. Having additional money sitting idly by in a checking account that isn’t even earning enough interest to keep up with inflation is certainly not ideal. It’s an opportunity cost, which is a risk in and of itself. The goal with investing is to make your money work for you, not to do work while your money is sitting around waiting.
The bottom line
You do not have to follow either value averaging or dollar cost averaging strategies to be a smart investor. They’re not for everyone, and each has their advantages and disadvantages. It’s important to think of them as tools. Maybe the best tool for you is to pick and choose the pieces of each that will work for you. For example, setting a consistent investing schedule so that you can keep emotion and worry out of your financial decisions, while still keeping an eye on opportunities to buy low and sell high.
Whatever you choose to do, keep in mind these essential investment principles:
- Invest regularly
- Use time to your advantage
- Diversify your portfolio
- Keep your investments in line with your risk tolerance and time horizon
- Don’t be afraid to seek help when you need it