Several months ago I explained in detail why value averaging doesn’t work. A quick summary: you have to have a pile of cash on the sidelines available to pour into the market if needed. Either that or you have to borrow deeply if the cash isn’t available.
Value averaging proponents calculate their strategy’s returns using the “internal rate of return” (IRR). The IRR can be a good way to measure returns, but in this case it means that we ignore the opportunity cost of idle cash and ignore the interest costs on borrowed money.
Hallam gives some results over a period cherry-picked to make value averaging look good: the 5 years from February 2008 to January 2013. Note that 2008 was the year the market crash began. Let’s say that you had $500,000 invested in U.S. stock index ETF VTI on 2008 Feb. 1 and began value averaging with a 9% per year return target and making adjustments each month.
By the beginning of March 2009, you would have borrowed a total of just over 363,000! It’s ridiculous to think that investors would have had this much cash on the sidelines or would have had the nerve to borrow this much to buy stocks while they were crashing. It’s equally ridiculous not to count the opportunity cost of cash on the sidelines or borrowing costs.
Here is Hallam’s attempt to acknowledge these concerns:
“Critics have wondered where the cash for aggressive purchases is supposed to come from when markets keep falling. Such a drop could force a depletion of the money market cash reserves if investors are continuing to transfer assets from cash to stocks. In this case, Bruce Ramsey suggests if there’s not enough capital in the money market account, then you either do nothing or invest whatever cash is available.”Are the return figures quoted by Hallam based on Ramsey’s suggestion to do nothing when you’re out of cash or are they based on borrowing hundreds of thousands of dollars? If they are based on the borrowing, does he factor in interest costs? Does he seriously think that investors should leverage themselves in this way?
Value averaging is a bad idea that sounds appealing until you really crunch through some numbers with real-life scenarios.