What is Value Averaging?
The golden mantra for wealth creation in the equity markets is, ‘buy the dip and sell the rip’. However, it’s easier said than done. This article provides an in-depth analysis of a popular investment strategy - Value Averaging, which helps investors in buying low and selling high.
Value Averaging
Value Averaging, or VA, is an investments strategy similar to Dollar-Cost Averaging (DCA). In DCA, investors need to invest a fixed amount every month. Since the dollar amount invested remains constant, investors buy more shares when the prices are low and fewer shares when the prices are high, thereby reducing the average share price. In VA, too, an investor needs to invest an amount every month, but that amount is not fixed in value average investing.
Value Averaging meaning entails making consistent contributions to the portfolio over time. The contribution differs each time based on the prevailing market conditions and begins by identifying a value path. Value investors set a target portfolio amount and then tweak the next month's contribution according to the relative gain or shortfall on the original asset base. They invest less when portfolio value rises and more when it falls.
Advantages of Value Averaging Investment Plan
Much like Dollar-Cost Averaging, Value Averaging attempts to help investors overcome their emotions of greed and fear, perhaps the most significant obstacles they face in their investing journey. This, in turn, leads to building financial discipline amongst investors.
VA also helps in avoiding market volatility by adjusting the investment amount based on market conditions. This investing system makes sure people invest very little money during a bull market that could likely be a bubble. However, the validity of this claim is widely debated.
Comparing Dollar-Cost Averaging and Value Averaging
Dollar-Cost Averaging
Dollar-Cost Averaging is similar to SIP or Systemic Investment Plans in mutual funds The amount invested each month remains constant. The reason investors buy more shares when prices fall is that the shares cost less. The table below shows how the concept of averaging works -
| Month | Amount Invested($) | Unit Price($ per unit) | Units Purchased (No.) | Total units owned (No.) |
|---|---|---|---|---|
| 1st | 10,000 | 40 | 250 | 250 |
| 2nd | 10,000 | 30 | 333.33 | 583.33 |
| 3rd | 10,000 | 50 | 200 | 783.33 |
| 4th | 10,000 | 60 | 166.66 | 949.99 |
Value Averaging
Unlike in Dollar-Cost Averaging, in VA, the amount to be invested in the next month depends on the portfolio’s performance in the previous month. VA does better averaging than Dollar-Cost Averaging by pumping in more money to work in a downward market and reducing investment when the market goes up. However, VA is not well suited for indisciplined investors. There can be periods which require no investment and the investors may splurge the surplus money.
Also, VA is best suited for a volatile market and does not work very well in a one-sided bear or bull market. Investments may decline drastically in a raging bull market, and investments would shoot up considerably in a bull market. VIP can generate good results only in an extremely long period - 10 years or more.
| End of month | Value Path ($) | Market value of the portfolio at month-end ($) | Investment or (withdrawal)($) | Per unit price ($ per unit) | Units purchased or (sold)(No.) | Total units owned (No.) |
|---|---|---|---|---|---|---|
| 1st | 10,000 | 10,000 | 10,000 | 40 | 250 | 250 |
| 2nd | 20,000 | 7,500 | 12,500 | 30 | 416.66 | 666.66 |
| 3rd | 30,000 | 33,333 | (3,333) | 50 | (66.66) | 600 |
| 4th | 40,000 | 36,000 | 4,000 | 60 | 66.66 | 666.66 |
Example of Value Averaging
Ms T wants her portfolio to be worth INR 120,000 by the end of the year. Accordingly, she has set her monthly goals to be INR 10,000, INR 20,000, INR 30,000, INR 40,000 and so on, such that by the year-end, her portfolio will be worth INR 120,000. Ms T starts building up her portfolio by investing INR 10,000 in the first month. By the month's end, her portfolio drops to INR 9,000. Hence, she now pours in INR 11,000 to meet her target of INR 20,000 by the end of the second month. In the third month, the market rises, and her investments are worth INR 23,000. She invests INR 7,000 now instead of the planned 10,000 to meet her monthly target of INR 30,000.
Value averaging may also suggest investors withdraw money from the portfolio if its value breaches the target. Continuing the above example, if the portfolio value at the beginning of the fourth month crosses over to INR 45,000, Ms T may be allowed to liquidate her holdings worth INR 5,000 to meet the target of INR 40,000.
Challenges to Value Averaging
Value investing faces two significant challenges. The first issue lies in identifying the value path, i.e., knowing the desired value of the final portfolio. Investors should also be able to factor in the impact of inflation on their desired growth rate and chart a reasonable value path accordingly. The factors affecting growth rates are dynamic. Investors may find it taxing to keep their value paths in tandem with constantly changing market conditions.
VA assumes people have deep pockets. When markets go southwards, it recommends increasing the investment amount. However, there is a strong possibility that investors' income might also take a beating during a market downturn. Moreover, having spare cash implies that people are not fully invested in the market, leading to suboptimal returns.
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Frequently Asked Questions
Dollar-Cost Averaging involves allocating a fixed amount of money at regular intervals for investments. The advantage of DCA is that it is as simple to practice as it is to preach. It is not easy to time the market, and DCA does not require you to do that and can be loosely compared to passive investing. Compared to Value Investing, DCA is often touted as a better investment strategy for the common investor for the same reason. However, for more vigilant investors who understand the economic cycles well and have deep pockets, Value Investing would be a more suitable choice.
Cost Averaging is the periodic investment of a sum of money to buy more shares when the prices fall and fewer shares when the prices rise. Cost averaging is a long-term investment technique that requires investors to purchase stocks regularly using a fixed sum of money, irrespective of the cost of the stock. The average purchase price is the average cost of the investment.
Lump-sum investing is investing a huge chunk of money in one go. Whether investors should go for Dollar-Cost Averaging or lump sum investing depends on their appetite for risk and volatility. With lump-sum investments, people should be ready to watch their portfolios ebb and flow. If one can not stomach market volatility, then Dollar-Cost Averaging is the way to go.