Use Value Averaging to Decrease Investment Risk

Most investors are familiar with dollar cost averaging, but few have even heard of value averaging let alone know how it might impact the risk associated with investing. The purpose of investing is to make a profit. In other words, buy low and sell high. To understand how value averaging can help an investor achieve these objectives, one must first understand the concept.

What is Value Averaging?

Instead of investing a set dollar amount at regular intervals like dollar cost averaging, the investor should determine the value he would like to achieve at those intervals. For example, let's say that an investor wants her mutual fund to increase by $100 each month. In a bull market, the value of the mutual fund may have already increased $80 so only $20 more would need to be added to the fund to increased its value to the desired amount. On the other hand if the fund lost $80 during the month due to bearish conditions, the investor would need to invest an additional $180 to achieve the necessary value.

The net effect of value averaging is to invest more money when the value is lower and less money when the value is higher accentuating the mantra of buy low and sell high. Essentially, this helps to decrease the risk of investing by lowering the overall cost of the investment more so than does dollar cost averaging.

In fact, value averaging would call for selling a portion of the investment if the value increased so much as to exceed the desired interval gain. Dollar cost averaging provides for no such sell rule. Selling when there is a gain may have tax consequences in a taxable investment account. In that case, the investor would simply not add any capital to the mutual fund until it would be required but would set that money aside for when the fund failed to make sufficient gains.