Value Averaging: A Smarter Way to Buy Stocks at a Discount

Introduction: The Investor’s Struggle with Market Timing

Even if you are a long term investor who is not concerned with short term price fluctuations, you still want to purchase stocks at low prices and sell at high prices. You do not actively try to time the market, but there is no reason to not take advantage of market fluctuations if there is a way to do so to your benefit.

Traditional strategies like lump-sum investing and dollar cost averaging (DCA) have their pros and cons and you already have your opinion on which one to prefer. Neither of these strategies is designed to take full advantage of market fluctuations.

Value averaging on the other hand is a strategy that forces you to buy more when the stocks are cheap and sell when they are expensive. And it does this without you having to judge the price levels yourself.

Let’s take a look at how this works and how to set up this system.

What Is Value Averaging and How Does It Work?

Value averaging (VA) is a systematic investment strategy that adjusts your contributions based on portfolio performance. This is different from dollar cost averaging. In DCA, you invest a fixed amount regularly. In Value Averaging, you increase investment when the prices drop and decrease the investment (or even sell) when the prices rise.

Let’s say you want your portfolio value to increase by $100 every month. Next month, the prices decline and your portfolio value decreases by $50. To ensure that the portfolio value is higher by $100, you will then add $150 in new investment so the resulting portfolio value is $100 above where it was last month.

On the other hand, if the prices have gone up and the portfolio has risen by $50, you will only have to add $50 in new money to get the portfolio to where you want: $100 increase over the previous month. Please note that if the prices have gone way high and the portfolio value has risen more than $100, you will sell the excess above $100 increase instead of investing any new money.

While this approach may seem complicated, it has a key advantage—it enforces the principle of buying low and selling high.

Why Value Averaging Works Better Than Dollar-Cost Averaging

DCA is passive but VA is dynamic. DCA invests regardless of price while VA responds to the market conditions. Using value averaging, you buy more shares when the prices drop and thereby amplifying the compounding effect. When the markets get overvalued, value averaging will make you reduce investments, which cuts your exposure to high valuations and reduces risk.

Historical backtests show value averaging outperforms dollar cost averaging and random investing over long periods, especially in volatile markets.

This strategy isn’t just theoretical—many seasoned investors use value averaging to maximize long-term returns.

The Math Behind Value Averaging: A Simple Breakdown

The math may look complicated at first, but it is actually quite simple once you start using value averaging. You can pretty much make a table by month or week on where you want your portfolio value to be, and then add or deduct what is necessary to bring the portfolio to this value.

The Target Value Formula:

Target Portfolio Value = Previous Target + Desired Growth Rate

Example Calculation:

You want your portfolio to grow by $500 per quarter. If it’s at $4,500 today and your target is $5,000, you invest $500. If it’s already at $5,200, you sell $200 worth of stocks.

Compounding Effect: Since you’re buying more when prices are low, VA enhances long-term compounding.

The way to make this work is to have a side-fund that holds cash in form of cash, money market funds, or something similarly highly liquid form. This side-fund is where you collect cash that is then used to fund or hold cash for your growth portfolio.

But while the math is straightforward, value averaging does have some practical challenges to consider.

The Challenges of Value Averaging (And How to Overcome Them)

Implementing value averaging can bring out some challenges that may be new to you. Let’s take a look at these.

1. Requires a Cash Reserve: You need cash on hand to deploy when stocks drop. Solution: Maintain a reserve fund or reinvest dividends. ideally you will hold these funds in a separate account at the same broker so they are segregated but funds are easy and quick to transfer between acount.s
2. Can Trigger Taxable Events: Selling in taxable accounts can create capital gains. Solution: Use tax-advantaged accounts like IRAs or rebalance strategically. If you are using tax-advantaged accounts, you may not be able to use a separate side-fund to hold your cash reserve. In such cases, you may just keep the extra funds in cash in your tax-advantaged account.
3. Works Best in Volatile Markets: In steady bull markets, it may underperform lump-sum investing. Solution: Use VA in volatile asset classes like small-cap stocks or cyclical sectors. Although historical backtests show value averaging to work better than dollar cost averaging in all markets, the advantage is smaller in a trending bull market.

Despite these challenges, value averaging can be a powerful tool—especially when applied to the right investments.

How to Implement Value Averaging in Your Portfolio Today

You can implement value averaging in your portfolio in just 4 simple steps. Before you start, make sure you pick a portfolio that contains volatile assets such as small-cap value stocks.

• Step 1: Set a Growth Target – Determine how much you want your portfolio to grow each period (monthly/quarterly). You can set your growth target in dollar terms. Setting a % growth target can very quickly become untenable.
• Step 2: Track Your Portfolio Value – Compare actual vs. target values regularly. You may want to do this at the end of the week or end of the month on a consistent schedule.
• Step 3: Adjust Contributions Accordingly – Buy more when the portfolio is below target; sell or invest less when it’s above. Use your side-fund to hold the cash if you sell in your portfolio, and supply funds when you wish to buy more in the portfolio.
• Step 4: Automate with Tools – Use spreadsheets, brokerage alerts, or portfolio tracking software. This doesn’t need to be too complicated – a simple spreadsheet with the growth targets set for the future month will be sufficient.

Implementing value averaging may take a little effort, but the payoff can be substantial over time.

A Smarter, More Disciplined Way to Invest

Value averaging enforces the discipline of buying low and selling high without emotion. It works exceptionally well in volatile markets, making it a strong strategy for small-cap value investors. While it requires planning and cash reserves, the rewards of higher returns and better risk management make it worth considering.

I generally take the existence of a side-fund as a positive. Every investor needs cash reserves separate from their investments to provide liquidity as needed. This strategy fits right in with the best practice for investors to arrange their financials.

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