Value Averaging / AIM by Edleson and Lichello
Value averaging was among the first things I’ve learned about while I was researching investing systems that supposedly make investing smarter. Value Averaging is a way to automate buying and selling of a single security.
So how does it work? Very easy. First think about what you should do, if you were a perfectly rational investor. You should buy when prices are low and sell when they’re high. Unfortunately it’s not always easy to abide by these rules. So Value Averaging (VA) makes it automatic.
To use VA on a stock, an ETF or anything else, you first estimate the growth rate of that particular instrument. Let’s say the growth rate is 7% per year. Then, you compare what the value of your holding should be if growth were linear (the straight line on the chart). Of course, reality does not work this way so the actual value of your holding will vary (the jagged line). Now, every so often, according to a regular schedule (the monitoring interval), for example every 1, 2, 3, 6 or 12 months, you compare the actual value to the value you were estimating. If your estimated value is higher, it means the price is currently too low, so you invest enough to make up for the gap and bring your holding back up to the estimated value. If the estimated value is lower, that means the price is likely too high, so you sell a part of your holding to reduce the total actual value to the estimated value. This makes sure you buy at low prices and sell at high ones, automatically!
If you want more precise information on how to use the strategy, check out these two books on Amazon (don’t mind the less-than-serious-sounding title):
- How to Make $1,000,000 in the Stock Market Automatically: (4th Edition) by Robert Lichello
- Value Averaging. The Safe and Easy Strategy for Higher Investment Returns by Michael Edleson
Now, the strategy does work, it’s even better than Dollar Cost Averaging, but it has some disadvantages:
- Since VA sometimes tells you to buy, you need to have some cash on hand. You cannot be fully invested.
- The monitoring frequency you choose determines how many trades you make, and how much in commissions you pay. Sometimes the trade may be very small in size and hardly worth it. There are two ways to mitigate this problem by limiting the potential amount of trades:
- choose a low monitoring frequency (3 to 12 months)
- define a cash amount below which a trade is not worth making for you
If you want to focus on trading a single instrument, and do so automatically without much decision-making, it’s a good thing to try.
I personally do not use it, however, because I prefer to stick with a more diversified portfolio with many stocks and bonds, and using AIM only makes sense with a single instrument – it’s too complex to use on every one of 20 holdings in a diversified portfolio.