Studies of Life

Learning by doing.

Value Averaging / AIM by Edleson and Lichello

04 November 2014 by Jim

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.

Illustration of Value Averaging

 

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):

Now, the strategy does work, it’s even better than Dollar Cost Averaging, but it has some disadvantages:

  1. Since VA sometimes tells you to buy, you need to have some cash on hand. You cannot be fully invested.
  2. 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.

2 comments | Categories: Investing | Tags: , , ,

Comments (2)

  1. Interesting but way to simple a description of value averaging, you did not mention that value averaging uses not one but two rates of growth. You did not mention the free spreadsheets people can get from the book web site.
    Lichello wrote two investing books, AIM and SuperPower investing. I strongly recommend getting and reading SuperPower investing. Lichello writes about his investment plan Syncrovest, that is designed to beat Dollar Cost Averaging. As far as my simple testing goes it seems to beat value averaging also. Something to think about.

    • You’re right, there are free spreadsheets available – I’ll be sure to update the post with a few links for those who want to have a look. I haven’t read SuperPower investing, but I’ll be sure to check it out then!

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