Value averaging is a more sophisticated way to spread out your investments than dollar cost averaging. With regular dollar cost averaging you invest the same amount every time at regular intervals. You don't change this at all so you'll impose rigorous mechanical discipline on yourself to ignore market drops and invest anyway.

If you don't have this discipline you'll probably do what most discretionary traders do, buy only when the market is going up and thus bias their timing toward buying on expensive days. In a nutshell this is why most people fail at investing, the total inability to ignore that little voice that tells them to wait until the storm is over and markets have recovered enough to look "safe".

There is another strategy that enforces a buy low and sell high discipline, and this is what value averaging is all about. Value averaging is the brainchild of Professor Michael Edleson, who wrote a book by that name which ran to two editions, unfortunately it is now out of print.

Instead of investing a regular amount, you plan your portfolio in advance. Now if you are expecting an 8% return from your portfolio, you start out your investment program by charting your future equity curve, assuming that you do get that 8% return. After completing your chart (which is easily done in Excel), you'll know in advance how much your portfolio is "supposed" to be worth on any given day into the future.

As market events unfold you will then know how much you are supposed to invest each month by subtracting the actual value of your portfolio from the theoretical 8% growth portfolio.

For example if your spreadsheet says you should now have $10,000 in your portfolio, but due to a poor market you only have $9,000, you know that this month you will need to invest $1,000. If in another month you have $14,000 in your portfolio, yet only require $13,000, you can sit back and not invest that month.

You can plan a portfolio over many years in this way, you could value average over the entire period until your retirement, recalculating your required investment contributions every six months, or you can invest over a shorter period and make payments more regularly.

Value averaging is very hard to do in practice unless you are disciplined, because it will force you to step away from the market when it is doing very well and to jump in with both feet when the market takes a dive. Do not underestimate how difficult this can be, especially when you see several months of above average growth or several months of big falls, in the former case you will lament not investing and in the latter you will lament investing at all. Nevertheless I think value investing is the closest thing there is to a perfect timing strategy.

You can use value averaging on individual asset classes as a form of tactical asset allocation, or you can use it on your entire portfolio.

A nice thing about value averaging is that it works quite well in reverse when you come to draw a pension from your portfolio. This is a good way to ensure that you are selling the most on up days. Value averaging is how I maintain an "income planned" portfolio on an ongoing basis, you'll read about income planning in the next article.

I have designed a very simple spreadsheet that will allow you to calculate the required contribution to value average a portfolio. You need to enter your account balance each month, and the spreadsheet will tell you how much you need to contribute to follow this strategy. Enter your own investment return and inflation assumptions in the yellow fields. It is a monthly spreadsheet, but it would be a fairly simple exercise for you to modify it for a semi-annual or annual contribution schedule.

Click here to see valueaveraging.xls