A Value Averaging Example

Suppose (for this example) you wanted to accumulate $50,000 of Vanguard 500 index fund by value averaging on a quarterly basis over one year. For our example, we will use the calendar year 2006. The target value of our portfolio at the end of each quarter is below*:

The NAV (share price) of the Vanguard 500 is going to be different at the end of each period. This means that the value of our holding is going to change from quarter-to-quarter. It also means that we don't know how many shares we will need to buy in each period until it is actually time to buy them. The NAVs of the Vanguard 500 on the four dates are shown below:

This means that we will have to invest a different amount of money in each period. Because the holdings that we purchase in previous periods keep changing in value, we will need to invest an undetermined amount in order to get the total value back to the amount in the first table.

Since this example is really a simulation done in the past, we can map out the entire process of getting to the goal of $50,000:

Take a look at the column "Dollar Amount to Add." Note that we did not just add $12,500 in each period to arrive at our total final value of $50,000. What explains these values? Take a look again at the NAVs on these dates. Notice that when the price went up, the amount of dollars we added went down and vice versa. In other words, more money was invested when the price was lower and less money was invested when the price was higher. This is good! This means we were able to purchase more shares with less money.

Below is a graph showing the share price and the amount of money invested. It shows the inverse relationship between the movement of the NAV and the amount of money invested in the quarter:

Contrast this with the chart showing what we would have done under Dollar Cost Averaging:

Under dollar cost averaging, we invest the same amount of money each quarter regardless of the NAV.

But wait a minute, since the overall thrust of the Vanguard 500 over the year was up, wouldn't Dollar Cost Averaging have resulted in a larger holding than Value Averaging? Indeed, it would. Below is a comparison of the two techniques in terms of their actual results.

Don't be fooled by the fact that the Dollar Cost Averaging method resulted in a larger holding. The rate of return was lower for Dollar Cost Averaging than for Value Averaging. We can tell this because the Average Price Paid for the shares is lower. I can hear what you're saying now: "That small difference is not worth the trouble!"

But in fact the differences in rate of return can be substantial. This example only contained four periods - which is not enough to get a good reading. Also, there are many other advantages to Value Averaging besides the rate of return. For more information see the Value Averaging One Pager.

*For the sake of simplifying this example, we've left out some important details. Value averaging has built in assumptions for inflation and for the expected rate of return of the asset or assets held. For this example, we are assuming both of these values are zero. To create a proper model, you would plug in assumptions for both inflation the expected rate of return. There is a very good, very concise explanation of the mathematics involved here.