Setting money aside for investing on a regular basis should be a central part of your personal finances. Many different budgeting systems are designed to help you devote money toward your long-term goals. How you invest the money, of course, is just as important. Value averaging is one such approach to regularly growing your portfolio. So, how can value averaging help you create value?
What Is Meant By Value Averaging?
Value averaging is based on the idea that you will seek to grow your portfolio by a specific amount during a set period of time (usually monthly or quarterly) through the continuous investment in particular assets. You will try to do this by averaging out the amount of money you invest during each interval, which will be based on how the assets you are purchasing are performing.
According to this strategy, you will invest less money during a bull market and more money when the market hits a snag.
In order to understand this in practice, let us take the example of Warren. Warren has determined that his long-term financial objectives require him to grow his portfolio by $1,000 every month. He decides to purchase an index fund to help him reach this goal.
The first month Warren utilizes this strategy, he purchases $1,000 worth of a specific index fund. The market is strong, and 30 days later, his initial investment is worth $1,100. Accordingly, the next month, Warren will only invest $900 into the same index fund. His average portfolio growth for each month is $1,000, which is where the name of this investment approach originates.
What Are the Benefits of Value Averaging?
There are three basic benefits of value averaging:
(1) Consistent contributions: Value averaging will guide you to continuously invest in the market, keeping your long-term horizon in mind. Because you are aiming to meet a specific monthly rate of growth, you will regularly monitor the market’s performance and adjust your contributions accordingly. You will continue to make contributions on a pre-defined basis, ensuring that your portfolio grows at a regular clip.
(2) Buying Low: Value averaging triggers additional investments when the market hits a rough patch, allowing you to buy when the market is lower. Of course, the flip side is also true, and when the market is up, you will spend less money to grow your holdings at your desired rate.
(3) Maximizing value: Value averaging can allow you to maximize the value of your investment dollars. Because you will be investing more when prices are down, your upside potential is greater than dollar-cost averaging. This assumes, however, that you are investing in a strong asset that is increasing in value. (If your investments are losing money, you will need to make greater contributions on a regular basis in order to meet your investment goals.)
What Are the Drawbacks of Value Averaging?
There are a number of drawbacks to value averaging as well.
(1) Downturns require more cash infusions: If your portfolio sinks in value, you will need to devote more money in order to keep pace with your investment objectives. In times when the market is truly bearish, and investments are dropping precipitously, this can consist of a much larger outlay than your regular contribution. Value averaging is therefore a riskier approach than dollar-cost averaging, when the ups and downs in the market do not have much impact on your decision-making.
(2) Hands-on approach: Value averaging requires you to closely follow what is happening in the market so that you can tailor your monthly investments accordingly. This demands a more active response than other types of strategies.
Is Value Averaging Right for You?
Value averaging is best suited for those who are eager to monitor their investment portfolio regularly and who have the means–and the constitution–to make up for shortfalls when the value of their investments decreases.
If you are prepared to make the commitment to monitor your investments and are not overly bothered by the potential to make up for shortfalls along the way, this can be a good strategy for you to consider.
Perhaps most importantly, value averaging will encourage you to make consistent contributions to your portfolio, gradually growing your wealth at a regular pace over time. If you have the discipline to follow this framework, value averaging can certainly help you to generate value.
Conclusion: Getting Value for Your Money
The value of long-term consistency cannot be overstated. The investors who perform the best over time are those who are able to regularly put money aside for the future.
Value investing will help you create the framework for investing money in a disciplined fashion, while also helping you grow your wealth month-after-month and year-after-year. That is perhaps the biggest value that value averaging offers investors.
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