I’ve been quite critical of the investing strategy called value averaging (VA). I’ve explained the reasons why it doesn’t work, and why the methods used by its proponents to measure its returns are flawed. One reader, Lost Cowboy, challenged me to dig deeper, and I’ve done that with some experiments.
In short, value averaging is a strategy where you choose some target investment return and buy or sell as necessary to keep your dollar-value in equities rising by this target percentage. If equities rise on their own by more than this target, then you sell some, and if they rise by less than the target, then you buy some. The theory is that this will force you to buy low and sell high. In practice, this strategy demands that you invest cash when you don’t necessarily have it available. Solutions to this problem severely undermine returns.
I dug up some historical U.S. S&P 500 stock returns, short-term interest rates, and inflation rates from Robert Shiller’s online data. I used data from the last 100 years to compare dollar-cost averaging (DCA) and value averaging (VA). In this context, DCA just means investing money when you have it. I assumed that an investor invests $1000 each month (adjusted for inflation) in today’s dollars.
With VA, things are more complex. You have to decide on a return target and decide how to handle the case when the strategy calls for investing cash you don’t have. I decided to try all return targets from 0% to 20% per year in 0.5% increments. I also decided that there would be no leverage. So, we begin with some cash on the sidelines that is available for investing if necessary. For example, if we target 20% cash on the sidelines, then only $800 per month gets added to the target for stock ownership each month. Of course, the actual allocation to cash will fluctuate based on how actual stock returns differ from the target return. I also credited the cash on the sidelines with interest based on Shiller’s data. I tried cash targets of 0%, 10%, 20%, 30%, 40%, and 50%.
Whenever the VA strategy calls for investing more cash than is available, we just go for 100% allocation to stocks and no cash on the sidelines. So, each month we add a fraction of the new $1000 to the VA portfolio target for stocks, increase the VA stock target by the target return percentage, and then adjust the allocation to stocks in the actual portfolio.
I ran the VA portfolios for 25 years, with a reset of the target allocation to stocks every 5 years. There are 901 rolling 25-year periods over the last 100 years, and I ran VA simulations for all of them. For each target return and target cash percentage I averaged these 901 portfolio runs. For the DCA case, I just had to run the 901 25-year simulations once and average them.
I did not take into account any trading costs, MERs, or taxes. Taken together, these costs tend to hurt the VA portfolios more than the DCA portfolios.
Before giving the big chart with all the results, here’s a spoiler. The average DCA portfolio ended up at $915,065, adjusted for inflation. As for VA, drum roll please ..., all choices of target return and cash percentage gave worse results than DCA. See for yourself:
You’ll notice that for the 0% cash case and high target returns, VA seems to get close to DCA. This is because for a sufficiently high return target, VA and DCA do the same thing. With an extremely high return target, VA never takes any money out of stocks, and both VA and DCA just put the $1000 into stocks each month. As we lower the return target, VA occasionally takes some money out of stocks when stock prices rise sharply, and this hurts returns.
The main takeaway from these experiments is that it has been good to be invested in stocks for the last 100 years. Despite the apparent logic of value averaging to cause investors to buy low and sell high, the opportunity cost of sidelined cash dominates any benefits. You’re better off to choose an asset allocation and stick with it than to try value averaging.