Value averaging

Reaping profits from investments and building wealth is a journey that needs proper planning and discipline. Various strategies are available for investment. One such strategy that has gained popularity is value averaging. In this article, let’s explore the workings of value averaging, including its formula, advantages and disadvantages for your better comprehension. 

What is value averaging?

Value averaging is the process of making monthly investments based on your financial goals. You would invest relying on how near you are to your objective at any given time, as opposed to a set amount each month. The value path that investors who utilise a value averaging approach must take depends on the goal they are attempting to achieve. The amount of growth you must realise over a predetermined time period in order to reach the broader investment goal is known as the value route.

How does value averaging work?

Value averaging calculates your monthly investment requirement by comparing the present worth of your portfolio to your total investment target. Therefore, you would reduce your monthly payment if your portfolio is increasing and you are making progress towards your goals. On the other side, you would increase your contribution to make up the difference if the value of your portfolio decreased. 

Acquiring more shares during periods of declining prices and fewer shares during periods of rising prices is the primary objective of value averaging or VA. 

Let’s look at a value averaging example. 

Arnab is an investor who wants to grow the value of his portfolio each month by ₹ 1000. In the month of July, the market conditions remain profitable, and his portfolio goes up by ₹ 600. Now, to meet his targeted growth, he will invest ₹ 400. No, again, imagine that in the month of October, the market faces a dip, and his portfolio goes down by ₹ 500. In this case, Arnab will have to invest ₹ 1500 to make up for the dip and get his portfolio back with his initial ₹ 1000 growth objective. 

Value averaging formula

Making a Value Path that outlines the investment’s goal level for each time period is the main step behind cracking the value averaging formula. To ensure that the holdings equal the desired value, all you need to do is make the appropriate investment or sale at each time.

The value path variables are as follows:

• t = Time period 
• V_t = Target value of the investment at the time period 
• C = Target initial contribution per period
• r = Expected growth rate per period of investment
• g = Expected growth rate per period of contribution
• R = Average growth rate of contribution and investment

R = (r + g) / 2

Value path formula – V_t  = C * t * (1 + R)^t

Value averaging: Advantages and disadvantages 

Like most strategies, value averaging comes with its benefits and shortcomings. The following sections highlight the advantages and disadvantages of value averaging.

Advantages of value averaging

The major benefits of value averaging are:

• Potential for higher returns: When compared to conventional fixed investing methods, value averaging has the potential to yield higher returns, which is one of its main advantages. Value averaging aims to take advantage of market variations by investing more during downturns when asset values are lower and less during upswings when prices are higher, potentially improving long-term returns.
• Disciplined investing: Value averaging encourages investors to follow a structured investment plan. By doing this, investors can stay focused on their long-term financial objectives and avoid making emotional decisions that are influenced by transient market swings.
• Alignment with long-term goals: Value averaging is a good fit for long-term wealth accumulation and investing goals. Through consistent investment over time and performance-based adjustments to investment amounts, investors can strive to achieve their target portfolio value within a given time frame.
• Reduced volatility in the portfolio:  Portfolio volatility can be decreased with value averaging. The total cost per share is less than average because investors purchase more shares in affordable markets and fewer shares in costly markets. This makes it less probable that market swings will negatively impact an investor’s portfolio.

Disadvantages of value averaging

The key disadvantages of value averaging are:

• Increased monitoring needs: Value averaging implementation necessitates routine portfolio performance monitoring and adjusting investment amounts as necessary. Not all investors, especially those who prefer a more hands-off approach, may be fit for this because it can be time-consuming and may require active management. It makes the process a bit more complicated. 
• Possibility of overtrading: If investors often alter their investment amounts in response to transient market fluctuations, value averaging could occasionally result in overtrading. Overtrading may reduce overall returns by raising transaction costs and taxes.
• Requires patience and discipline: Value averaging benefits from discipline, but patience is also necessary. It can be difficult for some people to resist the temptation to act impulsively based on brief market swings, but investors must adhere to their investment plan.

Dollar-cost averaging vs value averaging

Both value averaging and dollar cost averaging aim to promote stability in the frequency of your investments. But in action, they appear quite distinct. When you use value averaging, your monthly contributions are determined by taking your investing goals and portfolio value as a reference. In contrast, dollar-cost averaging requires you to invest the same amount of money each month, regardless of the size of your portfolio.

The idea behind dollar cost averaging is to assist you withstand market fluctuations. Your money goes longer when you invest during a bear market because you may purchase stocks and other assets at a lower cost. You purchase fewer shares when stock prices climb in an up market. 

For investors who may not want to be making monthly contribution modifications, dollar-cost averaging may be a simpler option to implement. You can programme an automated monthly investment into your brokerage account or individual retirement account (IRA) based on a specified dollar amount. Those who choose a more passive approach to investing find it intriguing.

There is no specific answer as to which one offers better returns. They have distinct return profiles based on your consistency, investment time frame and market performance. 

Conclusion

A strategic approach to investing, value averaging places a strong emphasis on long-term wealth generation, risk control, and disciplined investing. Investors may be able to increase returns while maintaining focus on their financial objectives by modifying investment amounts. They can do so in response to how well the portfolio is performing in comparison to a target value.

Value averaging offers a disciplined framework for wise investment and long-term wealth creation, even though it might not be appropriate for all investors or market conditions. Investors can take advantage of value averaging in their wealth management journey by comprehending the fundamental ideas and applying the technique thoughtfully. 

FAQs