Value Averaging and How Dynamic Strategies Bias the IRR and Modified IRR

Abstract

This paper demonstrates that the IRR is a biased indicator of expected profits for Value Averaging (VA) and for any other dynamic strategy which is based on a target return or profit level, or which takes profits or “doubles down” following losses. The modified IRR is similarly biased. VA is popular, but this paper demonstrates that it is an inefficient investment strategy (for any plausible investor risk preferences) and quantifies the resulting welfare losses. VA’s popularity appears to be due to investors making a cognitive error in assuming that the strategy’s attractive IRR implies greater expected terminal wealth.

Keywords: value averaging, dollar cost, formula strategy

JEL Classification: G10, G11