Become a better investor
Lesson in Course: Investing basics (expert, 12min )
I understand how dollar-cost averaging works. Is there an alternative liquidity managing strategy?
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. This helps prevent us from buying too much of an overpriced asset.
Let's assume we are starting with $4000 to invest in an index like the S&P500 ETF SPY. Instead of investing $4000 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.
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%.
In Q1, we invest $1000 into the SPY ETF, which buys us 3 shares at $333 each.
If we hit our target, we would expect to have $1068 by Q2 before we invest another $1000. So our value path for Q2 should be $2068 after our next $1000 investment.
For Q3 our value path should be $3208.
For Q4 our value path should be $4426.
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 $2068 if we invest $1000 again today. Instead, we need to invest ($2068-$738) or $1330 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 $1230 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 $2448 and if we are to invest $1000, we would be above our value path of $3208. We only need to invest $760 instead of $1000. So we purchase 2 shares at a total of $612 for this quarter's investment.
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.
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 from 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.