Sorry. I guess I’m being a tad judgmental. Let me simply say, I’m not smart enough to time the markets. Neither are about a million other super intelligent people (unfortunately, most didn’t know it until it was too late).
Since your emotions are the greatest enemy of successful investing, you need a system and a structure in place to help you navigate the emotional waves of investing.
Many people use a simple and effective strategy called dollar cost averaging. This is a great way to start investing. However, today I want to introduce you to another simple, yet effective, investing strategy called – value averaging. Remember, a winning combination is choosing the best investments and the best investing strategy.
As for the strategy, value averaging has been shown to consistently provide better returns than dollar cost averaging.
What is Value Averaging?
Value Averaging is an investing strategy where the amount you invest is determined by the current condition of the market. This might sound like market timing, but instead it is a disciplined investment strategy that helps you purchase more shares when shares are lower.
When the market is strong, you will not put as much money into the market. When the market is weak, you put more money into the market.
Value Averaging is based on the investment research done by Michael Edleson.
How To Start A Value Averaging Investment Strategy
When you start value averaging, you will need to answer two important questions:
- What is your total savings goal? In other words, how much money do you want to have saved and by what date?
- What rate of return can you reasonably expect? This illusive number should probably be between 8-10%.
Implement a Value Averaging Investment Strategy by Creating an Investing Path or Road Map
Now that you have your investing timeframe and dollar amount, you simply do reverse calculations to determine how much money you should save each year. These yearly amounts make up your investing path. This will be your personal investing plan.
An Example: Joe and Jill Investor
Joe and Jill investor want $30,000 in ten years. Joe and Jill expect an average return of 8%. Assuming an 8% rate of return they would need to invest $2,000 each year for the next 10 years.
Their investing road map would look like the following:
|Year 1||$ 2,160.00|
To simplify this example, let’s assume that Joe and Jill track their investing progress at the end of each year.
Joe and Jill At Year One
Let’s say at the end of year one the markets were really strong and their investments were up 15%
This means they would end the first year with $2,300 (($2000*.15)+$2000)). Since, according to their ‘investing path’, they need a $2160 balance at the end of the first year, they should invest $1860 into the market and $140 into a high interest saving account.
Summary at the start of year two:
Invested: $4,160.00 / High interest saving account $140.00
If Joe and Jill get an 8% rate of return, they will be on track. If it is less, they will fall behind their investing path.
Year two was a slow year and the markets only gained 6%. Their investment ($2,300+$1,860 @ 6%) is now worth $4,409.60. The total at the end of year two should be $4492.80. They are officially behind their ‘investing path’. Now they will need to add the full $2,000 contribution plus and extra $83.20 to help them get back on their ‘investing path’.
Summary at the start of year three:
Invested: $6409.60 / High interest checking account $56.80
On and on the cycle would go adding extra or adding less investment dollars into the market to help you keep on track to be sure you will reach your financial goal.
How often should you check your investing progress?
You can made this determination based on your own preferences. It certainly does not need to be done more than once a month, but waiting more than once a year would be too long. Some people prefer quarterly. The more frequently it is done, the better.
Value Averaging Investment Strategy Vs. Dollar Cost Averaging Investment Strategy
Advantages of Value Averaging
Value Averaging offers better returns than dollar cost averaging
With dollar cost averaging, you are always investing the same number of dollars each and every month (statement updated 5/3/10). Value averaging forces you to buy less shares when the market is higher and more when it is lower. Thus, it is an investment strategy that puts a structure to the old advice – buy low, sell high.
I won’t rehash all the dry numbers, but if you are interested in the numbers, statistical evidence, or more information, you can download the following (free) pdf by Paul Marshall – A STATISTICAL COMPARISON OF VALUE AVERAGING VS. DOLLAR COST AVERAGING AND RANDOM INVESTMENT TECHNIQUES.
Disadvantages of Value Averaging
More work is involved.
While you can automate your payments with a dollar cost averaging plan, you cannot with value averaging. Each month, quarter, or year, you will need to check your progress in comparison to the investing path. You will then need to make the necessary adjustments.
Your investments might fall too far behind your investing plan.
If you started value averaging at the start of 2008, by the end of the year rather than being up 8%, you would be down 35%. You might not have the money necessary to buy enough shares to get your investments back to the anticipated amount determined by the investing plan. If, however, you could have made up the difference, your value averaging would have paid off nicely.
The amount needed might be too hard to estimate.
Let’s say you are a young person saving for retirement 40 years down the road. There are so many retirement variables that it would be almost impossible to have an accurate value averaging plan. However, the closer you are to your deadline, the more feasible your estimates become.
It is difficult to guess the right expected return.
Will you get 6%, 8%, 10%, 12%? If possible, the lower you estimate, the more likely you are to reach your intended goal.
While value averaging does have some disadvantages to dollar cost averaging, it should in the long term outperform a dollar cost averaging investing strategy. It is a viable option for those who are disciplined and willing to do a little extra work.
For those that do not have time to setup strategies yourself, there are companies tha such as Betterment.
Do any of you use a value averaging investment strategy? Is it worth the extra time involvement? Does it sound like a good strategy to you?