Value averaging

Value averaging, also known as dollar value averaging (DVA), is a technique of adding to an investment portfolio with the objective of providing a 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. After the investment has under-performed, the investor will be required to buy more. Some research suggests that the method results in higher returns at a similar risk, especially for high market variability and long time horizons. Some research suggests otherwise.

Endorsements

Michael E. Edleson and Paul S. Marshall argue that Value Averaging can provide for an increased rate of return when compared to dollar cost averaging and other investment techniques. 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 bequeathed 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.

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.

Criticisms

Hayley (2013) rejects the claims made by proponents of VA. Edleson and Marshall base their claim that VA outperforms other strategies on the fact that it generates a consistently higher Internal Rate of Return (IRR). However, Hayley (2013) demonstrates that the IRR is a misleading measure of returns for strategies such as VA which systematically invest less after strong returns than they do after weak returns. This investment pattern makes the IRR calculation put more weight on earlier returns when they were high and less when they were low. However, this is a retrospective change (as VA invests more AFTER poor returns), so whilst it alters the measured IRR it doesn’t generate more wealth for the investor.

This study goes on to demonstrate mathematically that VA is an inefficient investment strategy since the same outturns can be generated using other strategies which require less total cash to be invested. In addition, compared to other strategies, VA requires more active management, and a large “side fund” of cash or liquid assets which can be used to make the periodic investments required by VA. It concludes that “VA’s popularity appears to be due to investors making a cognitive error in assuming that its higher IRR implies higher expected profits”.

The study accepts that VA will tend to outperform when there is mean reversion in market returns (e.g. a high return one month tends to be followed by a low return the following month), but even if an investor identifies a market which mean-reverts VA is unlikely to be the best strategy to use. Consistent mean reversion would mean that market returns are easy to forecast, so it would be easy to construct other strategies which would take advantage of this predictability more effectively than VA. Mean reversion in the market is not the same concept as regression to the mean as used by statisticians where retesting a non-random sample of a population tends to produce results that are closer to the mean than the original test. The existence of mean reversion in financial markets is controversial and is a subject of active research. If it exists, then it is almost certainly very slight.

Independent of the issue of mean reversion, the cash side account required for value averaging will always cause some amount of reduced return on the overall portfolio since the money in the cash account, on average, will be earning less than if it was in the main portfolio. Any benefits that value averaging provides in terms of market timing need to overcome this factor.

Because value averaging sometimes calls for the sale of assets even during an overall accumulation phase, there can potentially be additional transaction costs and restrictions. For example, some mutual funds have frequent trader policies. Some funds forbid additional investment in the fund within N months of a redemption from the fund. Some funds charge an additional fee for a redemption if there has been an investment in the last N months.

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