Value averaging is an investment strategy that advocates adjusting how much you put into the market each month based on your specific goals and how your portfolio is performing. That type of approach is a departure from dollar cost averaging, in which you invest the same amount periodically in order to smooth out the highs and lows of the market. Understanding how value averaging works can help you to decide if it’s right for you. You can also speak to a financial advisor who can help you determine if it makes sense for your financial plan.
What Is Value Averaging?
Value averaging means investing money each month, based on your investment objectives. Rather than investing a fixed amount every month, you’d invest based on how close you are to your goal at any given point in time.
Investors who use a value averaging strategy first start by determining the value path they need to follow, based on the target they’re trying to reach. The value path is the amount of growth you need to realize over a set time period in order to achieve the larger investment goal.
You can break this down monthly, quarterly or annually, depending on your preferences. Your value path can be defined as a set dollar amount or a certain percentage of growth. So, for example, you might need to grow your portfolio by 6% or $10,000 each year, depending on what your value path dictates. You’d then adjust your monthly investment contributions according to where you are on the value path.
How Does Value Averaging Work?
Value averaging works by taking into account the current value of your portfolio, relative to your overall investment goal, to determine how much you need to invest each month. So, if your portfolio is up and you’re ahead on your goal progress, then you’d adjust your monthly contribution down. On the other hand, if your portfolio’s value shrinks then you’d increase your contribution to making up the gap.
For an example of how value averaging works, assume you set a goal to grow your portfolio’s value by $1,000 each month. June ends up being a great month for the market and your portfolio goes up by $600. To meet your $1,000 growth target, you’d invest $400. Now, assume that in September, the market dips and your portfolio is down by $500. You’d have to invest $1,500 to make up the shortfall and get your portfolio back on track with your $1,000 growth goal.
With a value averaging strategy, you’re always looking at the bigger picture and where you want to go, investment-wise. That type of approach could work well for someone who has a clearly defined endpoint they’re hoping to reach, though it may require you to be more hands-on when making investment decisions.
Value Averaging vs. Dollar Cost Averaging
Value averaging and dollar cost averaging are both designed to encourage consistency, in terms of the frequency with which you invest. But they look very different in action. With value averaging, you’re using the value of your portfolio and your investment goals as a guide for calculating monthly contributions. Dollar-cost averaging, on the other hand, has you invest the same amount of money each month, regardless of your portfolio’s value.
In theory, dollar cost averaging is designed to help you ride out the changing moods of the market. By investing when the market is down, your money goes farther since you can buy stocks and other investments at a discount. When the market is up, you buy fewer shares as stock prices rise.
Dollar-cost averaging can be easier to apply for an investor who doesn’t necessarily want to be adjusting contributions each month. You can choose a dollar amount and set up an automatic investment in your brokerage account or individual retirement account (IRA) each month. That’s appealing to people who prefer a passive investment style.
Which is better for returns, value averaging or dollar cost averaging? There’s no definitive answer. Value averaging and dollar cost averaging can produce different return profiles, depending on how consistent you are, what you’re investing in, your time frame for investing and how the market performs over that time.
Is Value Averaging a Good Idea?
Value averaging is not for every investor and it may only be a good idea for people who are committed to more closely monitoring their investments. That’s not to say that dollar cost averaging means you can be completely hands-off with your portfolio but generally, it requires less work on the part of investors.
One of the biggest risks associated with value averaging is being able to make up shortfalls when the market is down. If you suddenly have to go from investing $1,000 to $5,000 to make up a gap, for example, that could make it much more difficult for you to keep pace with your investment goals
That might be acceptable if you naturally have a higher risk tolerance and/or you have a ready supply of cash in reserves that you could invest if need be. Value averaging can also yield benefits if you’re buying in when the market is up, since you may need to invest less month to match your monthly growth goal.
Value averaging probably isn’t the best option for investors who have a difficult time wrapping their heads around how the concept works or are more risk averse. If you do decide to venture in, it’s important to remember that just like any other investment strategy, value averaging does not guarantee that you’ll realize the level of returns you’re seeking.
The Bottom Line
Value averaging is one way to build a portfolio, but it isn’t for everyone. Even if you decide to move forward with the strategy, it’s important to keep consistency and diversification at the front of your mind. Sticking with a regular investment schedule can help you take advantage of the power of compounding interest over time. Staying diversified can help to manage risk through the market’s various cycles.
Tips for Investing
- Consider talking to your financial advisor about whether value averaging might be right for you. If you don’t have a financial advisor yet, finding one doesn’t have to be complicated. SmartAsset’s free tool matches you with up to three financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- Minimizing investment fees can help you to preserve more of your returns. Choosing the right brokerage and selecting cost-efficient investments can help. When comparing online brokerage accounts, it’s helpful to look at what they charge in trading commissions and administrative fees.
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