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I saw this question about value-averaging and had researched it a while ago without understanding how to apply it.

In theory, the idea is that you contribute to your account so that the total value of your account reaches a certain value. If your investments do well, you can contribute less. If your investments do poorly, you need to contribute more.

I don't understand how value-averaging works in practice. Suppose you are shooting for a $1M portfolio for retirement and you are half way there ($500K). Suppose that next month, your account balance should be $501,000 according to your value-averaging schedule.

If the market drops 10%, it seems like you would have to contribute $51K next month to succeed at value averaging.

Do I understand value averaging correctly? If so, how does it work in practice?

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It definitely looks like that's what VA strategy requires... I'm not sure how practical it is, would definitely like to hear from some proponent of it. –  StasM Dec 17 '10 at 18:41
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Value averaging has you shift the balance of your portfolio over time, not the amount of contributions. So you can only do it if you have a portfolio holding both risky assets (shares etc) and some cash.

You start out by making a plan about how much you will contribute every month and at what rate you expect the share part of the portfolio to grow. Perhaps based on 20th century data you think an 8% growth rate is reasonable. Or alternatively if you know your desired final amount obviously you can work backwards to a desired rate from that.

If in any month the share part is falling below its expected growth path, you would put more money into it: possibly your whole paycheck contribution plus some from the savings cash account. On the other hand if the share component is growing "too fast" you would put all your additional savings into cash. So if your investments are doing well, you're not supposed to spend the excess money, but rather to put it aside into a dedicated cash account to top up your share component when prices fall.

In theory, this has the auto-levelling benefit of Dollar Cost Averaging, but even better: when prices are high, you'll automatically buy fewer shares, or even sell some; conversely when prices are low you'll buy extra shares from your reserve account.

If it turns out your estimate was unreasonably optimistic, and over your lifetime shares only ever average 3%, you'll end up with an entirely share portfolio, and a bumpier ride than you might have liked. If you have horrible luck and over your entire investing life shares return less than cash (which has happened, though not yet in the USA), then this will be worse than a standard balanced portfolio.

The original book Value Averaging by Edelson has a pretty good explanation of various cases, though I would say some of the examples are worked in excessive detail.

I have not implemented this myself, one reason being that the amount I'm able to save from year to year varies, as it probably does for you, and so predicting a path is not quite so simple as he assumes. You could still do it I suppose.

I think you could get a very crude approximation to this by simply directing your savings into cash when the share market's rate of growth over the last several years is above what you think is the long term average.

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If you were to stick to your guns, then yes, that's what you'd need to do.

In practice, that kind of a hit should get your attention, and you'd be wise to look at why your investment dropped 10% in a month.

Value averaging, dollar-cost averaging, or any other investment strategy needs to be done with eyes open and ears to the ground. At least with value averaging you need to look at your valuation each month! From my own experience, dollar-cost averaging breeds laziness and I ended up not paying much attention to what I was investing in, and lost a fair bit of money.

Bottom line is you still have to think about what you're doing, and adjust.

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It's not unheard of for the market to drop 10% for a short time. As for looking at why, suppose you looked at it and found there's a recession around, so markets dropped. So, what would you do then? –  StasM Dec 19 '10 at 3:35
    
@StasM: I doubt I'd throw $50k at it because that would seem to be throwing good money after bad. –  mbhunter Dec 19 '10 at 5:24
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The idea is you would also have a cash allowance in the portfolio originally - say 25%. So in this scenario, 375K in stock and 125k in cash. and assuming the goal is 1K increase in stock value you would buy 38.5K of stock at the now lower price.

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Would you sell off stock back into cash if the market recovered? or keep it? –  Alex B Apr 22 '11 at 17:22
    
@Alex like other rebalancing approaches, you can implement it either by redirecting new contributions only, or by buying and selling. Edleson discusses that if, for instance, selling the stock after a rise would incur a tax liability, you might choose to just sit on it and stop buying any more. –  poolie Apr 23 '11 at 8:02
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The way I've implemented essentially "value averaging", is to keep a constant ratio between different investment types in my portfolio. Lets say (in a simple example), 25% cash, 25% REIT (real estate), 25% US Stock, 25% Foreign stock.

Lets say I deposit a set $1000 per month into this account.

If the stock portion goes up, it will look like I need more cash & REIT, so all of that $1000 goes into cash & the REIT portion to get them towards their 25%. I may spend months investing only in cash & the REIT while the stock goes up.

Of course if the stock goes down, that $1000 per month goes into the stock accounts.

Now you can also balance your account if you'd like, regularly selling stock (or the REIT), and making the account balanced. So if the stock goes down, you'd use the cash & REIT to purchase more stock. If the stock went up, you'd sell the stock, and buy REIT & leave more in cash.

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This is a pretty sensible approach but it's not actually Value Averaging. –  poolie Apr 23 '11 at 8:01
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