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Value averaging

Lesson in Course: Investing basics (expert, 12min)

I understand how dollar-cost averaging works. Is there an alternative liquidity managing strategy?

Eureka!

What it's about: Value averaging is an investment strategy where we invest more when markets underperform and invest less when markets overperform.

Why it's important: This strategy of using value paths is one way to keep us on track to reach our goals, and limits buying too many high-priced investments.

Key takeaway: We can use this strategy to limit buying too many high-priced investments and encourage buying investments at a discount.

Value averaging is an alternative buying strategy to dollar-cost averaging. Value averaging allows us, as an investor, to buy more when the asset price is low and buy less when the price is high. It helps prevent us from buying too much of an overpriced asset.

What is Value averaging?

An investment strategy where we make regular purchases of an investment over time. How much we invest at each interval changes based on how much we want our investment to grow each period.

 

How does it work?

https://www.youtube.com/embed/BMkapmD-d7c?start=26&end=173

Let's assume we are starting with $4,000 to invest in an index like the S&P500 ETF SPY. Instead of investing $4,000 right away in a lump sum, we decide to do it over the period of a year into 4 increments.

Let's break out the steps we need to do to set up our value averaging.

  1. Set a required return
  2. Use the required return to determine our value path
  3. Adjust investments for value average

 

1. Required return

Let's say we are expecting an annual return of 30%. We can set our required annual return to be 30%. If we take account of compounding, we can back into a quarterly return of 6.8%.

The math

(1.3)^(1/4) = 1.068

 

2. Value path

In Q1, we invest $1,000 into the SPY ETF, which buys us 3 shares at $333 each.

Determining our value path

If we hit our target, we would expect to have $1,068 by Q2 before we invest another $1,000. So our value path for Q2 should be $2,068 after our next $1,000 investment.

For Q3 our value path should be $3,208.

For Q4 our value path should be $4,426.

The math

Q3 VP = $1,000+($2,068 x 1.068) = $3,208

Q4 VP = $1,000+($3,208 x 1.068) = $4,426

3. Value average adjustment

Let's say we invested in 2020 and when Q2 comes around the market sells off sharply due to Covid-19. SPY is now priced at $246 a share. Our 3 shares are worth $738. We are now below the value path of $2,068 if we invest $1,000 again today. Instead, we need to invest ($2,068-$738) or $1,330 dollars to reach our value path.

Instead of buying 3 shares this time, we buy 5 shares priced at $246 for a total new investment of $1,230 to bring us close to our value path. (Note we don't have to match the value path perfectly.)

By June 1, the stock market has recovered and the SPY is now back to $306 a share. Our total portfolio is now worth $2,448 and if we are to invest $1,000, we would be above our value path of $3,208.  We only need to invest $760 instead of $1,000. So we purchase 2 shares at a total of $612 for this quarter's investment.

 

Actionable ideas

Value averaging is great for investors who use more of a fundamental approach to value companies. This approach includes reading and understanding the company's financial statements and forecasting future revenues and cash flows to calculate a required return. 

However, value averaging can also be used by beginners to prevent buying too much of an overvalued asset or stock. The required rate of return can be estimated based on what each investor is comfortable with. For example, I think Tesla is risky and I will only invest in it if it generates a 50% return for me every year, or else I would rather put that money to use somewhere else. I can use that 50% to create my own value path.

 

Supplementary materials

The video above continues and goes into the mathematical equation of how to calculate the value path. This is a good start (not required for the lesson) for experienced investors looking to model out the strategy in excel or google sheets.

https://www.youtube.com/embed/BMkapmD-d7c?start=173

Glossary

What is Value averaging?

An investment strategy where we make regular purchases of an investment over time. How much we invest at each interval changes based on how much we want our investment to grow each period.