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Is Value Averaging Your Answer To Stock Market Timing?
August 11, 2014

Is Value Averaging Your Answer To Stock Market Timing?

On July 3rd, 2014 the Dow eclipsed 17,000 points for the first time.  Investors in the S&P 500 had gained 120 percent in the past five years, 60 percent in three years, and roughly 20 percent in 12 months.

Feeling nervous about an upcoming crash, die-back or decline?

Always remember that new highs are normal.  If they weren’t, we couldn’t beat inflation with a stock market index. Investors should treat market highs as they would a daily horoscope. Both are entertaining.  But each is a lousy decision-making compass.

What if you disagree?  What if you've ignored the mountains of opposing evidence and think people can time the market by jumping in or out before a rise or a crash? If that's the case, I don’t want to burst your bubble.  So I’ll show you something that’s like market timing.

It’s called value averaging.  And studies say it works.  Instead of investing the same monthly sum, as with dollar cost averaging, you invest more when markets are in the doldrums and less when they’re scorching.  It follows investing’s famous mantra.  Buy low, sell high.

You don’t have to be a market expert.  And the method isn’t time consuming. Michael Edleson, a former Harvard professor, first described it in a 1988 article. In 1991, he wrote the book Value Averaging. In it, he argues the approach would have outperformed dollar cost averaging with the Dow stocks in 57 of the 66 years between 1926 and 1991, earning 13.77 percent annually, compared to 12.61 percent.

He updated the book in 2006.  He detailed the strategy and showed it continued to beat dollar cost averaging between 1991 and 2005.

Results are supposed to be even better when markets go nuts. Recall what happened to the Nasdaq index in the late 1990s. Dotcoms launched it from a cannon. Then it crashed. Value averaging with the Nasdaq would have given investors a 15.2 percent annual return between 1991 and 2005, compared to 9.6 percent with dollar cost averaging.

Instead of investing equal sums each month, investors sell a bit when profits rise above their expected growth rate.  When the investment doesn't meet their expectations, they buy more.

For example, assume you hope for a 10 percent annual return. This equates to a monthly compounding average of roughly 0.79 percent. In other words, if you earned 0.79 percent every month, your annual return would be 10 percent.

If you had $200 per month to invest in the S&P 500, you would determine how much your account would be worth each month if you earned 0.79 percent monthly.  After the first month, if your $200 earned 0.79 percent, it would have grown to $201.58.

Instead, if your account grew to $210, you would be $8.42 ahead of schedule.  In such a case, you would need to invest just $191.58 the following month.

In contrast, if markets had underperformed, you would add more than $200 to align the portfolio with the dollar value of the expected growth rate.

Investors need to couple their investments with a money market fund, allowing them to transfer some stock market profits to it when their investment growth strongly exceeds the pre-determined goal. Conversely, they transfer assets from the money market fund to stocks when the stock market falls, so they can take advantage of falling prices.

Some believe we’ve entered a new era of increased volatility.  They might warm to a value averaging approach.

But it doesn’t jazz everyone.  Simon Hayley published a critical study in 2012 for Sir John Cass Business School, in London.  He argues that previous studies comparing value averaging with dollar cost averaging ignored the cash that investors must carry on the sidelines to utilize such an approach.

It’s much like a mutual fund manager keeping a quarter of her holdings in cash.  Her stock picks might beat the market.  But her fund’s total return would be the resulting sum of the stocks and the cash within it.  In such a case, if her stocks earned 13 percent, her cash earned 1 percent, and the market gained 11 percent, the stock market would have beaten her fund.

Hayley’s study makes plenty of sense. 

But two questions emerge.  How much money must be kept in cash for the strategy to work?  And could your investment performance be strong enough to offset the piddling interest in a money market account?

As with many stock market questions, these two are unanswerable.  But similar to a horoscope, they are fun to ponder.

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This article contains the opinions of the author but not necessarily the opinions of AssetBuilder Inc. The opinion of the author is subject to change without notice. All materials presented are compiled from sources believed to be reliable and current, but accuracy cannot be guaranteed. This article is distributed for educational purposes, and it is not to be construed as an offer, solicitation, recommendation, or endorsement of any particular security, product, or service.

Performance data shown represents past performance. Past performance is no guarantee of future results and current performance may be higher or lower than the performance shown.

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