Monday, March 3, 2008

Value averaging, also known as dollar value averaging (DVA), is a technique of adding to an investment portfolio to provide greater return than similar methods such as dollar cost averaging and random investment. It was developed by former Harvard University professor Michael E. Edleson. Value averaging is a formula-based investment technique where a mathematical formula is used to guide the investment of money into a portfolio over time. With the method, investors contribute to their portfolios in such a way that the portfolio balance increases by a set amount, regardless of market fluctuations. As a result, in periods of market declines, the investor contributes more, while in periods of market climbs, the investor contributes less. In contrast to dollar cost averaging which mandates that a fixed amount of money be invested at each period, the value averaging investor may actually be required to withdraw from the portfolio in some periods.
Value averaging incorporates one crucial piece of information that is missing in dollar cost averaging – the expected rate of return of your investment. The investor must provide this information for the value averaging formula. Having this data allows the value averaging formula to identify periods of investment over-performance and under-performance versus expectations. After the investment has over-performed, the investor will be required to buy less or sell (selling high). After the investment has under-performed, the investor will be required to buy more (buying low). Research suggests that the method does indeed result in higher returns at a similar risk, especially for high market variability and long time horizons.

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