Your wealth creation and retirement partner

Why Value Averaging is a smarter way to invest

$100,000 invested in Australian shares in 1980 with dividends re-invested would be worth $3.42 million 30 years later. Thats a
respectable 11% annual compound return.
Yet despite this 11% annual return, many investors are reluctant to invest in the share market. Scared off by events like the recent
Global Financial Crisis, many investors opt for a lesser (though safer and less volatile) long-term return by investing in cash or
bonds. But what if there was a safer and less volatile way to invest in the share market?
Beyond Dollar Cost averaging
Many investors are already familiar with Dollar Cost Averaging. Put simply, Dollar Cost Averaging is when you invest a fixed
amount each month into shares regardless of whether the market is down, up or indifferent. By doing this on a regular basis, you
buy some shares when the market is cheap, some shares when the market is expensive and some shares when the market is fair
value. But in the long-term you will average your way into the share market and reduce some of the timing risk that is associated
with investing in shares.
As a strategy, Dollar Cost Averaging is a good way to invest into shares. It has two main benefits:
1.

It encourages investors to allocate money each month to a savings plan

2.

It takes some of the emotion out of the investment timing process (you invest every month, regardless of whether you
think the share market is over or undervalued).

Value Averaging is similar to Dollar Cost Averaging, except it takes the process one step further. With Value Averaging, you still
make regular monthly investments, but this time a decision is made to invest each contribution into either Cash or Shares.
So how do you decide? Well its all about Fair Value. As I mentioned earlier the Australian share market has made an average
return of 11% a year in the 30 years leading up to 2010. So lets be a bit conservative and assume that a fair rate of return (in
exchange for the amount of risk we are going to take) is 9% a year. If we have an investment time horizon of 30 years (maybe this
is when we plan to retire), then this allows us to create a Fair Value line. Lets assume you have the following investments and
savings in place and take a look at what the Fair Value line might look like:

Investments

$140,000 (Client, super)

$100,000 (other investments/savings)

Contributions

$1,000pm (Clients super contributions )

$625pm (Partners super contributions)
$2,000pm (household savings to investment portfolio)

Fair Value Target Return

9% a year

Time horizon

30 years

$80,000 (Partner, super)

$16,000,000
$14,000,000

"Fair Value" Investment Goal line, assumes 9% pa return

on your combined investments + your regular contributions

$12,000,000
$10,000,000
$8,000,000
$6,000,000
$14,107,640 is
your "Fair Value"
Investment Goal
after 30 years

$4,000,000
$2,000,000
$0
Nov-80

Nov-85

Nov-90

Nov-95

Nov-00

Nov-05

Nov-10

Palmer Portfolios Pty Ltd (ABN 41 533 933 417) is a Corporate Authorised Representative (no. 301761) of Palmer Portfolios Group Pty Ltd AFSL: 376719 ABN: 78 145 431 107

07 3333 2733 www.palmerportfolios.com.au FAX 07 3367 2889

STREET: Suite 16, 1 Park Rd, Milton Qld 4064
POSTAL: PO Box 718, Paddington Qld 4064
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Your wealth creation and retirement partner

Using Fair Value as a benchmark

From the above example you will see that our fair value Investment Goal line says you should have a little over $14 million after 30
years. Of course, the share market doesnt move in a nice straight line. To enjoy the above-average long-term returns of equities
you must be able to stomach a little bit of volatility.
But volatility is not always a bad thing. For many investors, when the newspaper headlines are screaming doom and gloom and
GFC, they rush for the exits and sell their shares. However, history has shown that this is exactly the wrong way to be behaving in
this way.
Smart investors have a portion of the portfolio set aside in cash for when markets behave irrationally. They buy low, when others
are selling in panic. With Value Averaging investors now have an automatic way of taking advantage of these irrational moments in
the share market cycle.
So how does Value Averaging work?
Lets take the same Fair Value line we just created and assume (just by way of example) that the exact same returns of the past
30 years are repeated for the next 30 years. This 30-year period also includes two so-called crashes in 1987 and 2008. Lets also
make the following assumptions:

Instead of investing ALL of your initial starting amount into shares, you start with 15% in Cash

When the value of your investments trades above this Fair Value line (due to normal market fluctuations) you sell down
your shares (i.e. increase Cash) to put aside for a rainy day when shares are selling cheap.

$20,000,000
$18,000,000
$16,000,000
$14,000,000

Note the market crashes of 1987 and 2008.

With Value Averaging, cash is automatically
accumulated "set aside" in good times
(usually preceding a crash) to buy investments
when the market falls.

$12,000,000
$10,000,000

Cash

$8,000,000
$6,000,000
$4,000,000

Portf olio value

$2,000,000

"Fair Value"
Investment Line

$0

You will notice two very important things...

1.

When the share market is doing well (like in the years leading up to the 1987 and 2008 crashes), your portfolio is slowly
accumulating cash. This is because the annual return on your investments is above your target return of 9% a year. So
under the Value Averaging strategy this cash is tucked away to use when the market falls below your 9% Fair Value
line, and shares are arguably cheap.

2.

The Value Averaging strategy has produced a higher internal rate of return over the 30-year time period, and by allocating
part of the portfolio to Cash it has experienced less volatility.

Palmer Portfolios Pty Ltd (ABN 41 533 933 417) is a Corporate Authorised Representative (no. 301761) of Palmer Portfolios Group Pty Ltd AFSL: 376719 ABN: 78 145 431 107

07 3333 2733 www.palmerportfolios.com.au FAX 07 3367 2889

STREET: Suite 16, 1 Park Rd, Milton Qld 4064
POSTAL: PO Box 718, Paddington Qld 4064
PH

Your wealth creation and retirement partner

The mathematics behind Value Averaging strategy

The Value Averaging strategy is based on extensive research and modelling. The original concept was developed by former Harvard
University professor Michael E. Edleson.
By creating random simulations of normal market behaviour, Edleson found that the process of Value Averaging is likely to produce
higher internal rates of return (IRRs) than simple Dollar Cost Averaging. Having a weighting to cash should also reduce the overall
volatility of your portfolio.
Advantages of Value Averaging

Value Averaging automates the buy low & sell high process and takes the emotion out of market timing decisions.

Helps clients visualise and stick to a long-term investment strategy, and to understand that market falls (and rises) are a
normal part of the investment cycle. Indeed, market falls now become an opportunity.

Having an automated strategy will stop most investors from making poor market timing decisions (i.e. panic selling when the
market falls, or buying more investments after an extended period of above-average returns).

By increasing your allowable cash weighting later in life, Value Averaging can help you to reduce your overall risk profile as
you approach retirement.
How often is cash adjusted?
In the example above we have assumed monthly contributions to the planned portfolio. However, the regular cash adjustment (the
decision whether to buy shares, or increase a clients Cash Weighting) does not need to be done monthly. In fact, when you take into
account transaction costs, it has been shown that adjusting the strategy quarterly produces the same long-term benefit, but with less
ongoing cost.
What about the underlying investments?
Value Averaging does not replace good investment selection. In the long-run, a portfolio will benefit from having exposure to a good mix
of growth and income producing investments. With the Value Averaging strategy, your portfolio will usually be split into two components:
1. Growth component. This will typically hold a diversified blend of both Australian and International shares, or share funds, and
will nearly always account for the majority of assets in the portfolio, according to your agreed Risk Profile.
2. Cash component. This can be invested in term deposits, fixed interest funds or at-call cash within the portfolio. The cash
component is also invested to maximise the return while sitting idle.
The majority of long-term returns will be from the Growth component. However, for those times when you are holding extra cash (waiting
for the market to correct) its important to ensure the cash is generating the best return possible.
But what if I am retired or approaching retirement?
Value Averaging is not reliant on the client contributing funds to the portfolio. Even if you are regularly withdrawing (i.e. to fund your
retirement lifestyle) you can use Value Averaging to construct a Fair Value investment line.
If you are retired or approaching retirement, it may be that you adopt a more conservative approach to Value Averaging. This can be
done by increasing your initial Cash Weighting (from say 15% to 40%), or by lowering your Target Return from say 9% to 6%. By
lowering your target return it is likely you will store more of your portfolio as cash in the years ahead, thereby reducing your Risk
Exposure later in life.

Palmer Portfolios Pty Ltd (ABN 41 533 933 417) is a Corporate Authorised Representative (no. 301761) of Palmer Portfolios Group Pty Ltd AFSL: 376719 ABN: 78 145 431 107

07 3333 2733 www.palmerportfolios.com.au FAX 07 3367 2889

STREET: Suite 16, 1 Park Rd, Milton Qld 4064
POSTAL: PO Box 718, Paddington Qld 4064
PH

Your wealth creation and retirement partner

How does Palmer Portfolios implement your Value Averaging strategy

Palmer Portfolios is a fully licenced financial advising firm, and one of the few in Queensland to operate a Limited Managed
Discretionary Account service. Called our Optimum Portfolio Service, it is an agreement between us and our clients to
manage both the underlying investments in our clients portfolios and the regular Cash Adjustments necessary for the Value
Averaging strategy (within agreed parameters).

To our knowledge, we are the only financial advising firm in Queensland offering Value Averaging as a long-term investment
strategy. It is a complete service encompassing a full Financial Plan and initial setup of a clients Fair Value Investment line,
the ongoing management of investments and cash adjustments in the portfolio, and quarterly reporting of your progress
towards your goal.
What else you need to know

More information on Value Averaging can be found online and also in the book Value Averaging: The Safe and Easy Strategy
for Higher Investment Returns. A free copy of which is available to any client who wishes to research this strategy further.
There is also a good summary of Value Averaging on the Wikipedia website, with links to further
reading http://en.wikipedia.org/wiki/Value_averaging

While Value Averaging has been shown to increase the internal rate of return (IRR) in a wide range of different market
conditions, there are no guarantees that this will be the case in the future. Having an allocation to cash will reduce the overall
volatility of your portfolio, but can lead to a lower overall return in times of exceptionally good market returns.

There can be capital gains tax (CGT) implications of selling investments in a rising market. While we always look to minimise
CGT, it is possible that CGT could be higher under this strategy. However, we believe this is offset by the reduced volatility and
likely higher returns of the Value Averaging strategy.

If you would like more information on the Value Averaging Strategy, I invite you to contact me personally.

Joel Palmer B.Bus, Dip FS (FP), C.Dec

Principal Adviser
Palmer Portfolios Pty Ltd
joel@palmerportfolios.com.au
ph 07 3333 2733

Palmer Portfolios Pty Ltd (ABN 41 533 933 417) is a Corporate Authorised Representative (no. 301761) of Palmer Portfolios Group Pty Ltd AFSL: 376719 ABN: 78 145 431 107

07 3333 2733 www.palmerportfolios.com.au FAX 07 3367 2889

STREET: Suite 16, 1 Park Rd, Milton Qld 4064
POSTAL: PO Box 718, Paddington Qld 4064
PH