"Buy low, sell high" must be the best-known investing advice in the universe, and it's the goal of nearly every individual investor. Of course, it's easier said than done -- and most of us aren't very good at recognizing the highs and the lows.
But there's a strategy that can greatly increase your odds of buying at the right time. Read on to learn why value averaging can be such a powerful tool for investors.
What is value averaging?
You may have heard of dollar-cost averaging, a strategy based on investing a fixed amount of money on a regular schedule. For example, you might pick out an S&P 500 index fund you like and buy $100 worth of shares each month. Because you're always buying the same dollar value of shares no matter what the market is doing, you'll end up buying more shares when the price of the fund is down and fewer shares when it's up. This will lower your cost basis and smooth out your returns somewhat.
Value averaging is similar to dollar-cost averaging, but it takes the strategy a step further. In value averaging, instead of investing the same amount of money each month, you pick a "growth goal" for your investment and put in however much money is required to hit that goal.
How value averaging works
For example, let's say you've decided to switch your S&P 500 index fund from a dollar-cost averaging to a value averaging approach. You currently own $1,000 worth of shares in this fund, and you want your holdings to increase by $100 per month.
At the end of the first month, you check your brokerage statement and see that the value of the fund has gone up a bit, so your shares are now worth $1,010. Because your goal is to hit $1,100 this month, you'd buy $90 worth of more shares in the fund. Next month, your goal goes up again by $100 to a total of $1,200 -- but the fund has had a bad month, so the value of your existing shares has dropped to $1,080. In order to hit your hundred-dollar growth goal this month, you'd buy $120 worth of new shares.
Value averaging pros and cons
The biggest benefit of value averaging is that you automatically end up buying a lot of shares when your stock of choice is low, and you buy fewer (or even zero) shares when it's high. Some investors who use this approach will even sell shares when they exceed their monthly growth goals. For example, if your shares in the S&P 500 index fund went up by $150 one month, you might sell $50 worth of shares to stay on target.
On the other hand, a value averaging approach can lead you to have a lot of cash sitting on the sidelines. If you're hanging on to your cash because your shares have already hit their growth goal and you don't need to buy more, then that money is missing out on the returns it could be earning if you'd invested it. If you find that this happens to you a lot, you should consider either adjusting your growth goals upwards or finding another way to invest that money.
The other big concern with value averaging is that if your investments go way down in value, you may not be able to invest enough to hit your growth goal for the month. In that case, don't go overboard and throw so much money into your investments that you can't afford to pay your bills. Instead, buy as much as you can comfortably afford and write off your goals for the month. Value averaging also requires more of a time commitment than dollar-cost averaging, as you have to work out how your shares are performing in order to calculate your investment for the month.
Should you use value averaging?
Value averaging is best for investors who don't have a great deal of money available for investing at present. If you have a lump sum to invest, your best bet is to put it into the market right away so that the money can start compounding. But if your paycheck is your only source of investing funds, deploying a bit of it in a value averaging strategy is a good way to maximize your results.