Value averaging is a strategy in which an investor selects a target growth rate to obtain during a specific time period (months, quarters, years) for the investment. If the investment fails to meet the target growth rate after the time period, the investor will then contribute money to the investment to bring it up to the target growth rate. If the investment exceeds the target growth rate after the time period, the investor will withdrawal money from the investment to bring it down to the target growth rate.
Let’s take a look at an example of value averaging.
An investor decides they want their investment to increase by 3% each quarter. The investor will start with $10,000.
- On Jan 1, stock ABC is trading at $10/share and the investor purchases 1,000 shares.
- In order to meet the 3% requirement, the value of the investment must be $10,300 at the end of the first quarter.
- On March 31, stock ABC is trading at $11/share. The investment value is now $11,000.
- This exceeds the expected balance by $700 ($11,000 – $10,300).
- The investor needs to sell $700 worth of this investment to be in line with the $10,300 expected balance. $700 / $11 share price = 63.63 shares.
- On March 31, the investor sells 63 shares (now has 937 shares) and now the investment has a market value of $10,307.
- In order to meet the 3% requirement, the value of the investment must be $10,609 at the end of the second quarter.
- On July 31, stock ABC is trading at $10.50/share. The investment value is now $9,838.50.
- This is below the expected balance of $10,609 by $770.50 ($9,838.50 – $10,609)
- The investor needs to purchase $770.50 worth of this investment to be in line with the $10,609 expected balance. $770.50/$10.50 = 73.38 shares
- On July 31, the investor purchase 74 shares (now has 1,011) and the investment has a market value of $10,615.50.
As you can see, this pattern will continue to guarantee that the balance at the end of the quarter always changes by roughly 3%.
Value averaging is definitely an interesting investing strategy because it forces the investor to purchase at low prices and sell at high prices. However, there are some significant disadvantages to value averaging.
- Capital Requirements – Significant capital may be required to offset large losses and bring the investment back in line with the target growth rate.
- Commissions – If you aren’t trading commission free, then those fees will weigh on your returns.
- Taxes – There is the potential to realize short term capital gains and pay a higher tax rate.
I put together a spreadsheet that shows an example of value averaging from Jan 2005 to Feb 2011 with the Vanguard Small Cap ETF (VB). If you decide you are interested in value averaging, you can use this spreadsheet as a template to track your investment. Let me know if you have questions about the spreadsheet.