NEW YORK (CNN/Money) -
When the stock market is in a downturn, is it a good practice to increase contributions to your investment accounts, thus buying more shares at a lower price? And when the market has provided a high return, would it not make sense to scale back contributions, buying fewer shares at the higher price?
-- Terry, Marion, Louisiana
What you're suggesting seems very much like an investing strategy that was floated back in the early '90s by Michael Edleson, who was then an assistant professor at the Harvard Business School.
He dubbed the strategy "value averaging," and even published a book on it titled "Value Averaging: The Safe and Easy Strategy for Higher Investment Returns." As far as I can tell, the book is out of print, although with a bit of digging you might be able to find a used copy.
In any case, Edleson's strategy is a refinement of the practice of dollar-cost averaging, which is much more widely known (though, in my opinion, still misunderstood) in investment circles.
The basic idea
Basically, the idea behind dollar-cost averaging is that instead of investing a sum of money all at once, you dole it out a bit at a time over a specific period. So, for example, if at the beginning of the year you had $12,000 you wanted to invest in stocks, you might invest $1,000 each month over the course of a year instead of investing it all at once.
The idea is that you reduce risk because you're buying stocks at a variety of prices throughout the year instead of buying all the shares at a single price.
Value averaging works a bit differently. With value averaging, you first figure out how much money you will need to accumulate for a goal such as retirement. Then, based on the annualized return you expect to earn on your investments, you figure out how much you must invest each month to achieve that goal.
So let's say you have a goal of accumulating $500,000 over the next 20 years. If you figure you can earn an annualized 8 percent, then you would need to put away about $875 a month. You can then chart your progress month by month towards that goal.
Here's where the "value" part of value averaging comes in. Let's say that, at the end of the first year, instead of having the $10,950 you should have to be on track toward your goal, a downturn in the markets leaves you with just $10,000.
That would mean that the next month, instead of investing your usual $875, you would invest an additional $950 to bring your portfolio's value to where it should have been to remain on track toward your goal. In fact, you would go through this process each month. In months where you fall behind, you would add to the amount you invest each month. And in months where your returns are higher than expected and your portfolio's value gets beyond where it needs to be, you would scale back your monthly investment, or even possibly end up selling some shares.
There are various ways to carry out this strategy. Instead of adjusting your investment amount each month, you could recalculate it every six months or every year. But that's the gist of how value averaging works.
One of the ideas behind this strategy is that it provides a much more systematic way of reaching a specific dollar goal than regular dollar-cost averaging. Since you are monitoring the value of your portfolio, you know down to the dollar whether you're on track and, if not, exactly what you need to do to get back on track.
But like any system, this one has some drawbacks. If the market goes into a prolonged slump -- or if you simply overestimate the return you can earn -- you could end up having to make very large contributions to keep your account value on track. If you're not able to double, or even triple, your contributions, you may have to abandon your plan, or create a new one.
The other thing you should realize is that neither dollar-cost averaging nor value averaging give you any real control over the returns you earn. The markets largely determine that. These types of strategies may be able to lower the volatility of your portfolio somewhat, but you may be able to do that even better in other ways, such as by simply building a diversified portfolio.
So it seems to me, the real benefit of strategies like dollar-cost averaging and value averaging isn't that they provide some magical investment alchemy that simultaneously boosts gains and lowers volatility. It's that they give you a disciplined framework for saving. And that's where their real benefit kicks in. They make you realize that you've got to save money to achieve goals.
Save as much as you can, regardless
I suspect that adhering to a strict value averaging strategy requires more work than most individuals would want to do. And, frankly, even if you are inclined to do the work, I'm not sure I'd recommend the strategy for long-term goals like accumulating a nest egg for retirement.
Why? Because following this strategy might lead you to invest less for retirement when the market is doing well, or in some cases even sell off part of your portfolio. I doubt that most investors are able to calculate the amount they'll need in retirement with sufficient precision -- or are likely to have retirement portfolios large enough -- to allow them to pare back their savings effort.
If anything, most people aren't saving nearly enough for retirement, so the focus should be on saving more, not less -- and not just in down markets as would be the case with value averaging.
So my recommendation is to save as much as you reasonably can regardless of what the market is doing. Yes, that will mean that at times you'll make contributions that will lose value over a certain period. But unless you can determine in advance what direction the market will take over the short-term, there's little you can do about that.
Besides, when you're investing for long-term goals, your ultimate aim is to reach the goal. And the more you save, the better the odds you'll attain that goal.
Walter Updegrave is a senior editor at MONEY Magazine and is the author of "Investing for the Financially Challenged." He also answers viewers' questions on CNNfn's Money & Markets at 4:40 p.m. ET on Monday afternoons.