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A Geek's Bookshelf: An Investment Strategy for the Long Term

Book Review - Value Averaging: The Safe and Easy Strategy for Higher Investment Returns

Any book that says it can teach you to beat the market is junk and the vast majority of these books seem to. Basically, if you don’t know anything about investing/financial stuff, or, come to think of it, even if you think you do, get a good primer like Andrew Tobias’s book that I mention at the end of the review. Tobias is a great writer and, in addition to his writing skills, has a pleasantly healthy amount of cynicism about the process. (There are other similar books – even the dummy’s book is pretty good.) Read one (and one only) of these books and then follow the standard advice they will give: invest for the long term and diversify. I’ll add: and don’t ever listen to the talking heads on financial porn channels like CNBC or what you will see/read in any other media. All of these folks claim to have some insights into what the market is doing or will be doing. Trust me, if they really knew, they wouldn’t be telling you. They’d keep their advice to themselves and be even richer then James Simon, who has made upwards of $1,000,000,000 a year for the last few years running a hedge fund that doesn’t claim to know what is going to happen or why what happened, happened but rather they work by harvesting small discrepancies between investments that should correlate – often these momentary discrepancies are actually caused by people who think they do know what is going to happen!

Yet here I am reviewing a book that purports to give a twist on investing that you can use (admittedly under very limited circumstances) in order to beat the results of simply buying and holding! To add insult to injury, the idea is actually more than 20 years old and the reprint edition I am reviewing is essentially an unchanged reprint of a book published in 1993 – 15 years ago. So what gives?

Basically the traditional mantra of investing over the long haul is to say: “dollar cost average.” This method is very common to retirement investing and simply means putting in the same amount of money regularly. Thus buying more shares when things are going down and less when they are going up. It’s disciplined, simple to follow and thus ideal for explaining to people. Trouble is it actually doesn’t work all that well in practice and Edleson was one of the first people to notice this and think about systematic ways to improve on it. (The definitive analysis showing dollar cost averaging doesn’t work well can be found here, by the way: http://www.studyfinance.com/jfsd/pdffiles/v13n1/marshall.pdf. This is a truly excellent and very readable paper that you should read right after you read Edleson’s book.)

What was Edleson's key insight? Basically he combined the need to rebalance a portfolio with dollar cost averaging and came up with a systematic strategy that, according to all the tests given it that I know of, delivers better results than dollar cost averaging with less risk, i.e., the holy grail of long-term investing.

Traditionally rebalancing worked like this: you had say 50% in stocks and 40% in bonds and 10% in money market funds. The stock market goes up, you now have 60% in stocks and only 32% in bonds and 8% in money market funds. You sell some stocks to bring the portfolio back into balance by adding to the bond and money market position. This is a good idea, and you should do it.

Roughly speaking what Edleson did was throw a form of automatic and dynamic rebalancing into the dollar cost averaging plan; roughly speaking he says the following: let’s imagine we want our investment portfolio to increase by 6% a year, always taking into account the added investments we are making. We build a little spreadsheet showing what we should have each quarter and enter what we actually had based on market performance. For example, something like Table 1 for a $1,000 a month investment where you can see that the needed monthly investment is increased quarterly in order to keep the portfolio growing at the correct rate. Contra wise, if the market went up more than 1.5% in a given period, you would shrink the amount you invest in the next period – if it really went up you may have to put no money in at all!

While Edelson gives some data showing the efficacy of this method over dollar cost averaging, it is actually Marshall who shows in the paper I just cited that there have been no 20 quarter periods in recorded stock market history or even in Monte Carlo simulations of hypothetical stock market performance based on historical norms where Edleson’s value averaging  strategy would not outperform dollar cost averaging in terms of risk/reward. He concludes that Edelson’s simple improvement to dollar cost averaging can work wonders on your risk/reward ratio over the long term.

Ah, but of course there “ain’t such a thing as a free lunch”: if you have a long-term downtrend in the market the amounts you have to put in to do value averaging can get really scary – and may not be possible for you – at which point the strategy would break down. The downside to value averaging is that while not quite as bad as “doubling down” at a casino, in a horrible bear market, it has some definite resemblance to it!

Still, Edleson’s value averaging strategy is one you should seriously consider if you have inherited a lump sum and want to deploy it over time, or if you were lucky enough to be say one of the first 1,000 employees at Google and have cashed in.

What Edelson’s book won’t tell you is which asset classes to invest in nor what percentages to use for them. (Check out Bernstein’s very nice book mentioned above for this or his great Web site http://www.efficientfrontier.com/.)

In sum I was convinced that once you have made the asset class decision, value averaging does give you a strategy to do the investing that seems to beat the conventional wisdom handily. Edelson’s book deserves to be a classic of the investing literature alongside books like Graham’s. Amusingly enough, the name of the series it has been reprinted in is the “Wiley Investment Classics!”

The Only Investment Guide You'll Ever Need by Andrew Tobias, Harvest Books; (January 3, 2005) ISBN: 0156029634

The Intelligent Asset Allocator: How to Build Your Portfolio to Maximize Returns and Minimize Risk by William Bernstein, McGraw-Hill (September 22, 2000), ISBN:0071362363

More Stories By Gary Cornell

Gary Cornell has a PHD in mathematics from Brown University. At various times and among other things he has been a professor, a program director at the National Science Foundation, and a visiting scientist at IBM's Watson Labs. He has written or co-written numerous best-selling and award-winning computer books. Most recently he co-founded Apress (www.apress.com), which under his leadership became one of the largest publishers of books for IT professionals in the world. And he did all this while simultaneously having a truly serious case of the 'gentle madness,' AKA bibliomania.

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