Value averaging

Value averaging, also known as dollar value averaging (DVA), is a technique of adding to an investment portfolio to provide greater return than similar methods such as dollar cost averaging and random investment. It was developed by former Harvard University professor Michael E. Edleson. Value averaging is a formula-based investment technique where a mathematical formula is used to guide the investment of money into a portfolio over time. With the method, investors contribute to their portfolios in such a way that the portfolio balance increases by a set amount, regardless of market fluctuations. As a result, in periods of market declines, the investor contributes more, while in periods of market climbs, the investor contributes less. In contrast to dollar cost averaging which mandates that a fixed amount of money be invested at each period, the value averaging investor may actually be required to withdraw from the portfolio in some periods.

Value averaging incorporates one crucial piece of information that is missing in dollar cost averaging – the expected rate of return of your investment. The investor must provide this information for the value averaging formula. Having this data allows the value averaging formula to identify periods of investment over-performance and under-performance versus expectations. After the investment has over-performed, the investor will be required to buy less or sell (selling high). After the investment has under-performed, the investor will be required to buy more (buying low). Research suggests that the method does indeed result in higher returns at a similar risk, especially for high market variability and long time horizons.

American financial theorist and money manager William J. Bernstein has stated that value averaging is superior to lump sum investing and dollar cost averaging for deploying a large sum into a portfolio. In this case, Professor Edleson recommends a VA period of three years. He suggests an infusion or withdrawal of capital every three or six months. For example, if one were to win or be bequethed one million dollars, roughly 8.33 percent, with the exact amount being set by the formula, could be invested every quarter. It is important to note that the quarterly or semiannual amount can vary greatly, even resulting in a withdrawal, as mentioned above. Opponents argue that this misses the opportunity of already being fully invested when a large market upswing occurs. This argument against value averaging and dollar cost averaging and in favor of lump sum investing ignores the suggestion of Ben Stein and Phil DeMuth that it is more important to avoid a large market downswing, which is theoretically equally possible, since market movements are essentially unpredictable. Participating early on in a large market downswing has been shown to be devastating to the success of long term retirement, for example.

Value Averaging a 401(k)

Author Timothy J. McManaman further outlines the benefits of Value Averaging when applied to the popular 401(k) tax qualified investment vehicle. As stated in McManaman's book, Building a 401(k) Fortune, Value Averaging a 401(k) is a precise method of making periodic internal transfers between Equity and Money Market funds within a 401(k) to take advantage of market fluctuations. This is accomplished by initiating minor movements out of Equity funds when the overall market trends higher and back into Equity funds when the market moves lower. It is essentially buying fund shares at a lower base price and selling them a higher base price within a tax qualified 401(k) on a monthly or quarterly interval. As outlined by Michael E. Edleson and Paul S. Marshall, Value Averaging can provide for an increased rate of return when compared to dollar cost averaging and other investment techniques.


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