Investing a varying amount each month
Value averaging works in much the same way as dollar cost averaging
. The difference is that with this strategy, you decide on a target amount to invest, then adjust your monthly contributions, either up or down, to maintain that target.
The strategy can help lower your average cost per share in a similar manner to dollar cost averaging. But value averaging goes one step further.
How Does it Work?
The idea is to invest more money when prices are low and less when prices are high, rather than the same amount of money every month as in dollar cost averaging. This provides the opportunity to reduce the average cost per share even further.
For example if the goal is to increase the value of the portfolio by $500 dollars every month, then each month the target should increase from an initial investment, say $5000, by $500. Ideally, the target will change from $5000 to $5500 to $6000 and so on.
But if the market rises during a month, the target will be exceeded if $500 is put in, so less money is injected in the next month to stay on target. On the other hand, if the market falls, a greater amount than $500 will need to be invested to remain on target.
It's a strategy that doesn't try to guess where the market is going. It tries to make those up and down market movements work in your favor.
A potential downside to the strategy is that if there is a severe downturn during a particular month, the amount that has to be injected for the next month may be significantly greater than $500. The investor needs to have the funds available to keep the strategy on track.
A number of independent studies have shown that over periods of a number of years, the strategy can produce slightly better returns to dollar cost averaging.
To Conclude ...
Do I use this strategy? ... No. But for investors who are slowly increasing their exposure to equities by investing part of their monthly salary, this approach may help to lower the average cost of investing over time.
For those who have come into a considerable sum of money through some means or other, for example an inheritance, following a slow drip approach into the market through this type of strategy may be a more sensible approach than investing it all in one tranche when market conditions may not be the most favorable.
The related article below examine the related strategy of dollar cost averaging.
Dollar cost averaging
: Also attempts to reduce the average cost of investing, but with a fixed dollar amount of additional input each month.
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