HOW VALUE AVERAGING WORKS

Basically, the idea behind dollar-cost averaging is that instead of investing a sum of money all at once, you invest it a little bit at a time over a specific period. So, for example, if at the beginning of the year you had $12,000 that you wanted to invest in stocks, you might invest $1,000 each month over the course of a year instead of investing it all at once. This is essentially Dollar Cost Averaging where the idea is that you reduce risk because you're buying stocks at a variety of prices throughout the year instead of buying all the shares at a single price. Dollar cost averaging is a “Buy low, buy less high” strategy, as there are no rules for selling.

Value Averaging works a bit differently. With Value Averaging, you first figure out how much money you will need to accumulate for a goal such as retirement. Then, based on the annualized return you expect to earn on your investments, you figure out how much you must invest each month to achieve that goal.

So let's say you have a goal of accumulating $500,000 over the next 20 years. If you figure you can earn an annualized 8 percent, then you would need to put away about $875 a month. You can then chart your progress month by month towards that goal.

Here's where the "value" part of value averaging comes in. Let's say that, at the end of the first year, instead of having the $10,950 you should have to be on track toward your goal, a downturn in the markets leaves you with just $10,000.

That would mean that the next month, instead of investing your usual $875, you would invest an additional $950 to bring your portfolio's value to where it should have been to remain on track toward your goal. In fact, you would go through this process each month. In months where you fall behind, you would add to the amount you invest each month. And in months where your returns are higher than expected and your portfolio's value gets beyond where it needs to be, you would scale back your monthly investment, or even possibly end up selling some shares.

HOW VALUE AVERAGING DIFFERS AND WHY IT WORKS

While either approach (VA or DCA) could dominate over any time period, value averaging has the edge most of the time because it is more aggressive. However, value averaging requires more monitoring, more transactions costs, and because it triggers sales, potentially more tax consequences. Value averaging can be modified so that no sales take place, with future value increases adjusted to compensate. Also, the loss potential is greater for value averaging because the total amount that is required to be invested is unconstrained.

At first glance the VA strategy may not seem too different from DCA, however there are significant differences:

• A large upward price swing often results in the sale of shares, instead of a purchase.
• VA also results in a net average cost per share that is much lower than the average cost per share with DCA.
• There is often a tendency to sell shares when the share price is high; the best DCA can do is buy fewer of the more expensive shares
• VA takes a more extreme response to market dips and rises than does DCA. The return is enhanced greatly by the larger purchases at low prices and by the profit taking as shares are sold at generally higher prices.
• VA forces you to avoid big moves into a peaked market or panic selling at the bottom
• VA tends to provide the highest returns in the stock market over short to immediate term investment periods.

Value Averaging (like DCA) helps investors to tide over market volatility without worrying too much about market timing.