Andrew Hallam wrote a piece in the Globe and Mail that likened enhancing performance in sports by blood doping to an investing method due to Michael Edelson called “value averaging”. Value averaging is simple enough to understand, and if you use the wrong method of evaluating its results, it seems to boost returns. However, the reality is that it doesn’t boost returns, and it drives up your investing costs.
The idea of value averaging is to keep your portfolio increasing at some target rate, regardless of what happens in the market. For example, if you target a 0.5% return each month, if the market goes up more than 0.5%, you sell some of your portfolio; otherwise, you add more cash to buy more assets. No matter what happens in the market, your portfolio rises steadily.
An immediate problem arises: where do I get this cash to pour into my investments when the market drops? The answer is that you’re supposed to keep a side pot of cash that you either put money into or take money from each month. Over time this pot of cash could either dry up or become quite large depending on how the market moves. To deal with this, the strategy calls for a reset every so often (say 3 years) where you reset the cash level to some fixed percentage of your portfolio’s size.
The selling point of value averaging is that you add money when the market is down and pull money out of the market when it’s up; buy low and sell high. This gives an internal rate of return (IRR) that beats the market return and also beats dollar-cost averaging. So far, what’s not to like?
The problem is that the IRR calculation only takes into account the money actually invested in the market. It ignores the cash that you have to keep on the sidelines. However, this cash is real money that you have to keep around earning low returns.
When you factor in the cash, value averaging gets worse returns in most markets than a simple buy-and-hold strategy. It isn’t hard to see why this is true. At any given time, a buy-and-hold investment is fully invested. However, a value averaging investment is only partially invested. The tendency for markets to go up creates an opportunity cost for the cash on the sidelines. This cost exceeds the boost that comes from a higher IRR.
One remedy for this problem might be to start with no cash on the side and plan to borrow as necessary to run the value averaging strategy. However, there is a gap between the best interest rate you can get on your cash and the lowest interest rate you can get when borrowing. This gap serves as a drag on value averaging returns. Another problem with this remedy is the possibility of becoming highly leveraged if markets drop significantly.
If you are interested in a more technical critique of value averaging, read Simon Hayley’s paper Value Averaging and How Dynamic Strategies Bias the IRR and Modified IRR. He concludes “Value averaging does not boost profits, and will in fact suffer substantial dynamic inefficiency. It also imposes additional direct and indirect costs on investors as a result of its unpredictable cashflows. The strategy thus has very little to recommend it.”
With the promise of lower returns and higher trading costs with value averaging, I’ll happily stick to my buy-and-hold approach with occasional rebalancing.