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OPINIONS

Value Averaging

Is it a better alternative to DCA?

Andy Chan

Andy Chan

04 Jan 2021

Level 10·Associate Software Engineer at GovTech

The strategy of dollar-cost averaging (DCA) is probably not foreign to most retail investors. We commit a fixed sum over a period of time instead of committing an initial lump sum. By doing so, we are able to:

  • Reduce the impact of volatility on the overall investment

  • Remove the need to time the market

  • Purchase more shares when the prices are down, and less when the prices are up.

However, there is actually another strategy similar to DCA - Value Averaging (VA).

It is similar to DCA in that we still invest across a period. What distinguishes this from DCA is the amount we invest each month.

How Value Averaging Works

Value averaging (VA) is a concept introduced in 1988 by Michael Edleson, who later wrote a book on it in 1993.

Similar to DCA, VA is a formula-based approach where you set an amount to invest in over a period. For example:

  • For DCA, you would perhaps set aside a fixed $200 per month to invest.

  • For VA, you adjust this amount depending on how your portfolio performed in the previous period.

Let's go through an example. Let's say you want to increase the value of your portfolio by $200 per month. You currently have $2,000 in an asset.

  • If the investment value increased to $2,024, you only invest $176 (200 - 24) to ensure that your account only increases to $2,200.

  • However, if your investment value decreased to $1,900, you would invest $210 (200 + 10) to ensure that the account increases to $2,200.

You'll maintain this strategy for subsequent periods until you reach your investment objective.

So what does this do?

Well, the goal of this method is to acquire even more shares when the prices are low, and fewer shares when the prices are high, relative to DCA.

  • When the portfolio underperforms, you need to invest a larger amount to 'top-up' the portfolio.

  • Conversely, when the portfolio outperforms the expected growth, you'll simply invest a smaller amount, or even sell off some shares to maintain the current growth rate. The amount received from selling off shares or not investing can then be used as a buffer for when the portfolio underperforms.

How you can use VA in your investments

For retail investors, this is another strategy we can consider when saving up for big-ticket items.

When the markets are overvalued, the amount received from selling off shares or not investing can be placed in relatively safer investments like cash management accounts to continue to earn some returns.

Hence, even when the market declines when our investment objective is nearing its end, we still have this buffer that can help cushion the impact.

DCA vs VA

Let's now do a brief comparison to see how VA fares compared to DCA, assuming that the investment objective is $5,000 after 5 periods.

Declining Market

  • VA resulted in a higher loss as the investor needs to invest a larger amount each period to make up for the losses. However, the number of shares owned for VA is higher.

Rising Market

  • VA did not perform as well as DCA in a rising market, since the idea is to own fewer shares when the prices are high.

A rise followed by a fall

  • Again, the number of shares owned by VA is higher than that of DCA.

A fall followed by a rise

  • The gain from VA is higher, although the investment value for DCA is higher.

Should you use VA over DCA?

It really depends. If you're okay with some level of downside risk, then perhaps DCA might be a better alternative since the market always trends upwards, and you own more shares compared to VA in a rising market.

VA seems to be a strategy more suited when the market is volatile, allowing you to purchase more shares when they are at a discount and fewer shares when they are overvalued and due for a pullback.

Drawbacks of VA

As with every investment strategy, VA comes with some limitations.

Limitation 1: Difficult to time entry/exit via a robo-advisor

  • Since a "middle-man" is handling your investments for you, it is difficult to buy/sell off shares at a specific price. This means you might potentially be buying when the prices have risen, or selling when the prices have fallen.

Limitation 2: Need to take into account other costs

  • If you're investing via brokerages, you will need to take into account fees associated with it, especially for brokerages that do not offer $0 commissions.

Limitation 3: Need to be able to commit in a declining market

  • As seen above, you will need to be able to invest more in a declining market to ensure that the portfolio grows according to the amount you set per period.

Limitation 4: Assumes that the market eventually trends upwards.

  • Value averaging assumes that the market eventually trends upwards. A risky asset may continue to decline due to poor fundamentals, and using this strategy on this asset may result in larger losses.

Concluding Thoughts

Whether you should value average or dollar cost average really depends on your investment objectives.

VA is a possible strategy you can consider if you are okay with actively buying/selling every period. Otherwise, DCA works if you just want to passively set aside a sum of money every period.

Alternatively, you can continue to DCA and pump in more money when there is a downturn or correction, which some in the community are already doing. This way, you still buy even more shares when the prices are low. This is also probably the more fuss-free approach.

DISCLAIMER: Opinions expressed here are my own. What may work for one person may not be applicable to another. Do your own due diligence.

Resources

https://www.investopedia.com/terms/d/dollarcostaveraging.asp

https://www.investopedia.com/terms/v/value_averaging.asp

http://www.sigmainvesting.com/advanced-investing-topics/value-averaging

Comments

Rachelle Lye

Rachelle Lye

29 Dec 2020

Level 14·Digital Marketing Associate at Seedly

Great read for beginners!

What are your thoughts?

Reply

ABOUT ME

Andy Chan

Andy Chan

04 Jan 2021

Level 10·Associate Software Engineer at GovTech

Salaryman

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