Value Averaging: A different path to investment success

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There are three types of Investment strategies. These are Fixed Share, Fixed Dollar and Value Averaging.

In fixed share strategy, you buy fixed number of shares of a company regularly over an extended period of time. For example, you buy one share of Infosys each month for say 24 months. As the prices rise, you will invest more amount and as prices fall you will invest less. Your average prices is the simple average of the prices you paid over your investment horizon.

Fixed dollar strategy is also known as 'Dollar Cost Averaging (DCA)' or 'Systematic Investment Plan (SIP)'. In this approach you invest a fixed amount regularly over an extended period of time. For example you will invest 10000 rupees every month for 24 months to buy shares of Infosys. If the price of Infosys goes up, you will buy less number of shares if the price of Infosys goes down, you will buy more number of shares. In this way, your share purchases mirror your normal purchase behaviour. Since you are buying more number of shares when prices are lower, your average price ends up lower than the simple average prices that you get in Fixed Share approach.

Investors can create significant long-term wealth just by using this strategy. It is simple, intuitive and reliable. Studies have shown that this is the ONLY approach where you will NEVER lose money. Most important, you welcome market crashes. That is your opportunity for you to pile on juicy shares at throw away prices !. This is the only approach most of the investors will need. 

With investment portals like ICICIDirect and Zerodha, SIP on Shares is very easy to do. You can give standing instructions to invest any amount to buy any share of your choice. Once you place that standing instruction, only thing you need to do is to ensure that money is available on the due date. 

However there is one problem with SIP. It is that this approach instructs you only to buy. It never advises you to sell. So you can't automatically take money off the table during market bubbles, you will end up buying if any, during those periods, when you should be selling.

Enter Value Averaging.

In value averaging approach popularized by Harvard professor Michael E Edleson, you 'control' your portfolio value. You start your investing with a targeted portfolio value. Let us say that you want to grow your portfolio to become 120000 in 12 months. You do your math and decide that to meet your target, the value should be 10000 in month one, 20000 in month two, 30000 in month three etc for twelve months. In the month one you invest 10000 rupees. 

In month two, let us  say that markets are up and your original 10000 investment is worth 12000 at the end of month one. So in month two, you invest 8000 to meet your target value for month two. If in month two market crashes and your portfolio is worth 18000 rupees, you will invest 12000 rupees in month three to ensure the portfolio value of 30000 at the end of month three. 

Note that you are investing less amount as markets go up and risk increases. This is a perfect risk management strategy.

Another advantage is that unlike SIP, this approach helps you to take money off the table during market bubbles as well. Let us say that at the eighth month, your expected portfolio is 80000 but the portfolio value is 90000. So in this month, instead of adding 10000, you will sell your shares to bring the portfolio value back to 80000. In this way, this strategy guides you when to buy as well as when to sell. 

One drawback of this approach is that as your portfolio size grows, you may find it difficult to find the money required to invest as per the recommendations of this approach. For example, in the month eight, instead of 80000, the market value is 60000, you will need to invest 20000 rupees to meet the portfolio target. This throws your budget under the bus and some accounts like retirement accounts can't even afford that amount.  

The other drawback is that you may not be able to capitalize in times of continuous market upswings. But that is fine. By regularly selling at those times, you avoid future regrets of not having capitalized on the bull market.

After all, all of us are not looking to become Warren Buffets, are we?