Value averaging is an investment strategy that sets a predetermined target amount for a specific period. The investor either buys more shares if the value of his investments drops or sells shares if the value drastically increases compared to the target value. The investor sets the interval and the predetermined amount either in fixed additional amount or in increasing additional in amount. The concept of this investment strategy is basically buy when the market drops and sell when the market is high.
Unlike Cost Averaging, Value Averaging requires more time and effort to keep your investment on track. In some instances, a large cash reserve is needed in order to keep the investment on track in the event of a correction or market crash. Value Averaging requires more discipline and control of emotion compared to Cost Averaging since investors are required to counter the markets movement.
To better understand the difference between Lump Sum, Cost Averaging and Value Averaging we will test each of these investment strategy using historical values of the Philippine Stock Index. We will use Php 5,000 monthly investment on cost averaging as our base point. For our Value Averaging we will use an increasing amount of Php 5000 every month. We also used a monthly interest rate of 0.797%, which is equivalent to roughly 10%, on our predetermined amount to match the average annual growth of the Philippine Stock Market.
LUMP SUM - COST AVERAGING - VALUE AVERAGING 1986 - 2014
A person who invested in the Philippine index fund back in 1986 a sum equal to the total cost of Cost averaging will out perform both Cost Averaging and Value Averaging by a large margin. The total cost of investing Php 5,000 a month from Jan 1986 - Apr 2014 is Php 1,705,000. The lump sum investment back in Jan 1984 will garner a return of Php 81,187,519.40 which is equivalent to a 4761.73% return in 28 years or approximately 10.76% annually. The effect of compounding interest has greatly benefited the lump sum investor in this scenario.
COST AVERAGING VS VALUE AVERAGING 1986 - 2014
Since lump sum investment is clearly the better option in this illustration let us examine how Value Averaging performed against Cost Averaging. In the 1986-2014 data, Value Averaging has out performed Cost Averaging by more than Php 2,000,000. There is also a large difference between the investment cost of both strategies. After 28 years, the total investment cost for Cost Averaging has reached Php 1,705,000.00 while Value averaging has already regained the investment cost.
LUMP SUM - COST AVERAGING - VALUE AVERAGING 1994-2014
In our second scenario, Value Averaging outperformed both Cost Averaging and Lump Sum investing. This scenario illustrates what happens when you start investing during the peak of a bull market and the beginning of a bear market.
This scenario is one of the reasons why some people opt to spread their investment instead of investing it in Lump Sum. It took more than nine years (April 1997- Nov 2006) for the Lump Sum Investor to recover his lose, 7 years for the Cost Averaging Investor (April 1997 - Aug 2004), and only 6 years for the Value Averaging Investor (April 1997 - Dec 2003).
Gains made on Value Averaging is more than twice that of Lump Sum Investing. Cost of investment is significantly lower than Lump Sum and Cost Averaging.
LUMP SUM - COST AVERAGING - VALUE AVERAGING 2004-2014
Our third scenario is based on the 2004-2014 historical data. Lump Sum Investors earned more than the returns of both Cost Averaging and Value Averaging Investors combined. Although Value Averaging had the least gains in the past ten years, it also has the lowest investment cost among the three.
After examining the three scenarios, Value Averaging usually has the lowest cost in the long run since value averaging is the only strategy among the three that sells when the price is high. Value averaging also recovers faster from a lose among the three. In this comparison Value Averaging often out performs Cost Averaging and depending on the circumstances has out performed Lump Sum Investing.
The major disadvantage of Value Averaging is the unpredictability of the cost. The amount needed to match the predetermined amount is dependent on the market fluctuations. When the market drastically drops, the cost may be to high to match the predetermined amount. In some instances, cost of matching the predetermined amount exceeded the lump sum or total cost for the cost averaging.
In order to decide which investment strategy to use, examine how these investment strategy performs in different situation. Making decisions is easy when your investment is gaining. It is a different story when your investment is at a lose for almost a decade. Imagine yourself in this situation in order to determine how you will react in those situation.
These investment strategy are useful when you are investing in index funds, mutual funds, trust funds or blue chip companies. These methods are simplified investment strategies which will lessen your risk and offer good returns. In order to get great returns one must be willing to exert more effort in learning how to evaluate stocks and know what stocks to buy, when to buy and at what price to buy.
One factor that I did not include in this comparison is the fees that Value Averaging Investors will incur by constantly buying and selling his / her stocks. I excluded this to simplify my comparison.