Key Takeaways:
- Value averaging is an investment strategy developed by Michael Edleson
- Michael is a Managing Director at Morgan Stanley. Earlier he was Chief Economist of NASDAQ & a finance professor at Harvard Business School. He has a PhD from MIT.
- Value averaging is conceptually like SIP & re-balancing done together
- Value averaging forces you to buy more than SIP when markets are low and suggests a possible sale of units when the markets are high
- Over 66 one year periods value averaging was higher than an SIP by 1.16%
- At the extreme, in a beaten down “bear” market SIP yielded 11.25% while Value averaging: yielded 25.86%
- Over 5 year periods, on average Value Averaging was higher than an SIP by about 1.13% than SIP
- Value averaging can generate exceptionally high returns during market crashes
- This strategy can easily be implemented using a spreadsheet
In an earlier article of mine, I explained 2 novel investment strategies Dr. Bernstein recommends one could employ to take advantage of market downturns. One of them was Value Averaging. This article explains how you can quickly & easily implement this approach using a spreadsheet to earn higher returns.
What is value averaging?
In very simple terms one could think of Value Averaging as an alternate approach to doing an SIP. Like SIP you can invest small amounts gradually over a long period of time.
One could also think of it as an SIP with constant re-balancing. Unlike SIP it involves both buying and selling. It forces you to buy more than SIP when markets are low and suggests a possible sale of units when the markets are high.
More on the concept of value averaging in my earlier article here
Who is Michael E Edleson?
Michael came up with / founded the value averaging approach. He is a Managing Director of Morgan Stanley and oversees the firm’s equity risk globally. Prior to that, he was Chief Economist of NASDAQ and a finance professor at Harvard Business School. Edleson earned his PhD at MIT.
Full credits therefore due to him for this article.
Why consider value averaging
Does this really yield better results than an SIP in the real world? To substantiate that I quote data from Michael’s book. This is based on data from 1926 to 1991 of the US stock market. I have summarised conclusions of his from two sets of data. One set is based on Value Averaging done over a 1 year period and the other from Value averaging done over a 5 year period.
For 1 Year periods:
- Value Averaging had a higher return than SIP for 58 of the 66 years analysed from 1926 to 1991
- When it beat SIPs it was on average 1.24% higher than SIP and when it lost it was on average 0.58% lower than an SIP
- Over 66 one year periods value averaging was higher than an SIP by 1.16%
- At the extreme, in a beaten down “bear” market SIP yielded 11.25% while Value averaging: yielded 25.86%
For value averaging over 5 year periods
- Value averaging had higher returns than an SIP in 52 out of 62 5 year periods.
- On average Value Averaging was higher than an SIP by about 1.13% than SIP for 5 year periods
There is one HUGE potential benefit of value averaging above that the above data does not convey. And that is if you happen to be doing Value Averaging during a crash in the market. If you have a crash during your value averaging cycle you could make enormous gains.
How to implement value averaging with a spreadsheet
All you need to do to implement the value averaging approach is to put 5 inputs into the template spreadsheet. Below I’ll explain what each input is.
Final investment goal: Cell B3
Your final retirement amount from the steps outlined in my earlier article goes in the cell next to Final investment Goal
Value of current existing equity investments: Cell B4
Enter the current value of your equity / stock market assets / holdings in the cell labelled “Value of current holdings”. Note that the value you enter here is the value of your existing investments in EQUITY ONLY. So for example, let’s say you’ve been investing in equity mutual funds for the last 10 years and that has already grown to a value of say 1 crore, then you enter that current value here in cell B4.
Note that if you have other investments like a home or any other real estate, PPF, FDs or other non-equity / stock market investments that value should NOT be entered here. This is because the sheet assumes that these investments will grow at the rate at which equity investments will rise. You need to calculate the final value of other such investments separately.
Months remaining till you reach retirement: Cell B5
If retirement is 10 years away that’s 120 months and so that’s what you would enter in cell B5 titled “months remaining”
MONTHLY Expected return on investments Cell B6
Here you are being asked to estimate the average return you expect to get from your equity investments. Note that what you enter in this cell is a MONTHLY rate of expected return not an annual rate.
This is tricky and there is no easy or correct answer. To play it safe, you might want to look at historical data on returns of the asset class or asset classes you are investing in. Typically pre-tax Sensex returns have been in the vicinity of 10%. But as with all things in finance, it’s always be cautious and err on the safer side i.e. in this case assume the lowest possible returns. Just as an example I have randomly picked a return of 0.7% per month
Another approach suggested by a number of financial advisors is to assume returns r to equal historical average retail inflation.
MONTHLY Increase in SIP amount: Cell B7
Under “Increase in SIP amount (g)” enter the maximum percentage by which you think you can increase your SIP each month. Note that this is MONTHLY increase figure not annual.
So if for example you expect to be able to increase your SIP by say 6% per year, you would enter 0.5 in this cell i.e. indicating a 0.5% per month possible increase in SIP
If possible, it’s probably a good idea to increase your investments at the rate of inflation. If you do decide to take this approach, you could utilize public historical data on retail inflation. But as another article of mine explains, public data on retail inflation could be rather misleading. So the ideal or best option would be to use your own personal inflation figure and fill the monthly figure for that into cell B7
Likely Monthly investment needed
Once you have entered all the above values from cell B3 to cell B7, you should look at the value in cell B13 – Avg. approx. amt / mth. (In this case Rs. 8,203/-) This is the APPROXIMATE amount you will likely have to invest every month in the value averaging approach. If this amount looks manageable move on to the next step.
If this amount looks too high, experiment with & play with different values in cells B3, (final value goal) B5 (months to reach goal) & B7 (increase in investment each month) till you get a value in B13 that looks like a manageable monthly investment.
Getting Your Value Path
Cell C19 and below are telling you what the VALUE of your portfolio should be each month from now. So if periods from now 0 corresponds to March 2025, the sheet is telling us that in April 2025 (Month 1) in order to meet our goal in 10 years, the VALUE of our equity portfolio should be 1,00,98,849.
Now when you look at your portfolio in April, if the value is for example still at 1 crore due to a bear market, then you would buy or invest an additional Rs. 98,849/- next month to bring your portfolio value to the amount mentioned in the Value Path for April (Month 1).
If, on the other hand, the market has risen and your portfolio value shows 1.01 crores in April, then you would sell units worth Rs. 1,151/-
That’s it. It’s as simple as that. You refer to your value path values each month. If you are below, you buy units so your portfolio value catches up to the value defined on the path for that month. If it’s above you sell units so your portfolio value is lowered to what is showing on the value path,
Disclaimer: I am not a financial advisor. My articles are meant for people who are not savvy or well versed with personal finance and investing and find it difficult to grasp all the jargon typically used when discussing such topics. I hope to be able to demystify investing and make it as simple as possible for everyone. I am merely someone like millions of other common folk who have been investing in Mutual Funds. I’ve invested in Mutual funds for approx. 24 years. I’ve also been a diligent student of the subject of investing over the past 24 years learning & applying the writings of luminaries in the field. In these articles I’m merely sharing my experience & learning from that investing journey and the books of luminaries in the field in the hope that it might help others in some way. Neither am I in any way directly or indirectly claiming to be a hot shot investor who has generated exceptional or even above average returns during my investment journey. However, I am quite confident that even if all you do is learn from my mistakes, educate yourself on sound investment principles & develop good financial habits you will benefit greatly. Please ensure that you consult a financial advisor before taking any decisions or actions concerning your personal finances or investments. I shall not be liable.