Value averaging can add value to your investments

In our article published in Mid-day Gujarati edition on 30-Nov-15, we discussed some limitations of SIP. This time, we offer an alternative to SIP. Value averaging can add value to your investments and take care of some limitations of SIPs. Click here to read further ...


The English translation of the two articles combined is as under:

Very often people ask this question, “So many financial advisors keep talking so many good things about SIP. Is there anything negative about it?” Come to think of it. Can there be something that is only good and without any limitation?

Well, SIP is not without any limitations. It has two serious limitations.

(1) That the asset prices have to go up in the long term, and

(2) During the investment period, even when the market is at a high level the investor keeps investing (though one buys fewer units)

Well, some may argue that these limitations are not very serious or that these are no limitations at all. Even if someone believes so, let us look at the word “limitation” with an objective to explore if there could be something better.

Incidentally, there is, at least in theory.

Let us look at the second of the limitations we have highlighted, that in SIP, we keep investing even when the markets are at high levels. The advocates of SIP would argue: Is it possible to know in advance if the markets are high or low? And since we do not know in advance, we keep investing and the principle of “Rupee Cost Averaging” takes over.

This principle of Rupee Cost Averaging helps us reduce the cost of purchase. When we invest a fixed sum of money in equity mutual funds, which have volatile NAVs, we buy more units when the NAV is low and fewer when the NAV is high. This happens automatically since the units allotted are a function of the amount invested divided by the prevailing NAV. This, by itself, turns the stock market’s inherent volatility do work for the investor.

However the fact remains, even though one buys fewer units, one does buy something even at market peaks. Let us see if at market peaks we can stop our investments or even take some money out of the investments.

Michael Edleson, a former professor at Harvard Business School promoted an approach that can improve upon the SIP. This approach does not keep the investment amount constant, but changes it – either the amount is increased or decreased. Incidentally, the investment amount is increased when the markets are low and vice versa. This approach is popularly known as “Value averaging”.

While in case of SIP, the regular investment is kept constant, in value averaging, the attempt is to keep the monthly (or whatever period one has chosen) value constant. As we all know, the value of investments (NAV of an equity mutual fund) would regularly change in line with the movement in the market prices. When this happens, the fresh investment amount would be adjusted such that the value is restored to a predecided level. Let us understand this with an example.

Assume that we have decided to invest ₹ 10,000 (or close to that amount) monthly. We also expect the market to go up @ 12% per year over the long term. However, this upward movement is not expected to be smooth and there would be periods when the market moves up much more or even goes down a lot.

Under value averaging, the investment would be varied as under (the price changes are assumed and only for the purpose of illustration):

Column 1	Column 2	Column 3	Column 4	Column 5	Column 6	Column 7
Month	Investment	Value at the beginning of the month	Value at the end of the month	Target value	% Change in market price	Change in investment amount
1	₹ 10,000.00	₹ 10,000.00	₹ 10,500.00	₹ 10,100.00	5.00%
2	₹ 9,600.00	₹ 20,100.00	₹ 19,954.00	₹ 20,301.00	-0.73%	- ₹ 400.00
3	₹ 10,347.00	₹ 30,301.00	₹ 29,984.00	₹ 30,604.01	-1.05%	₹ 347.00
4	₹ 10,620.01	₹ 40,604.01	₹ 40,992.00	₹ 41,010.05	0.96%	₹ 620.01
5	₹ 10,018.05	₹ 51,010.05	₹ 51,197.00	₹ 51,520.15	0.37%	₹ 18.05
6	₹ 10,323.15	₹ 61,520.15	₹ 62,150.00	₹ 62,135.35	1.02%	₹ 323.15
7	₹ 9,985.35	₹ 72,135.35	₹ 72,849.00	₹ 72,856.71	0.99%	- ₹14.65
8	₹ 10,007.71	₹ 82,856.71	₹ 81,645.00	₹ 83,685.27	-1.46%	₹ 7.71
9	₹ 12,040.27	₹ 93,685.27	₹ 95,329.00	₹ 94,622.13	1.75%	₹ 2,040.27
10	₹ 9,293.13	₹ 1,04,622.13	₹ 1,05,504.00	₹ 1,05,668.35	0.84%	- ₹ 706.87

The first column indicates the month number. The second is how much fresh money one has to invest. The third shows the value of portfolio at the beginning of the month, that is why in the first month both the amount to be invested and the start value are the same. The fifth column is the expected value, if the portfolio grows @ 1% during the month. This value is arrived at by adding 1% appreciation to the value at the beginning of the month in the column 3 for the respective month. However, as we discussed earlier, this does not happen in real life. In reality, the amount would go up in some months and down in some. This value (randomly arrived at) is captured in column 4.

If the value in column 4 is higher than that column 5, it means the market went up more than the expected 1% per month. In such a case, the next month’s investment is to be adjusted down from the original ₹ 10,000 per month.

The big advantage of value averaging is that one can plan to reach a target portfolio value – could be the expected value of the financial goal. Whenever there is a shortfall on account of adverse market movement, there would be small adjustments through increased investments and vice versa. This would ensure one reaches the financial goals comfortably and more assuredly.

Columns 6 and 7 capture the relation between market movement in the previous month with the subsequent month’s investment. As can be seen in the graph below, the amount to be invested changes in opposite direction to the previous month’s market movement.

This adjustment is an improvement over SIP.

Also please notice that the swings in investment amounts are quite large as time goes by. The value of the portfolio is such that after a while small movements in market value of portfolio would lead to major changes in the amount to be invested. This means, after few more months or may be a few years, we are likely to see some money being taken out of the fund. This is exactly what some investors may prefer to do – taking money out when the markets are high.

Sounds good. However, this is not so easy to implement.

How do you adjust your cash flows in line with the changing investment amount month after month? As seen above, as the time passes, the changes could be too large. In fact, in the 10^th month, the investment required is 20% more than what one started with. How can one suddenly save so much more?

Some mutual fund companies have innovated to take care of this issue. They have introduced systematic transfer plans that work on the principle of value averaging. This means, instead of transferring money from the bank to an equity fund, the investor puts lump sum amount in a debt (or liquid) fund and then transfers to equity fund. This takes care of the cash flow issue, too.

The salaried individuals can invest in a debt (or liquid) fund through SIP and then after building some corpus start value averaging through systematic transfer into an equity fund of one’s choice.

-        Amit Trivedi

The author runs Karmayog Knowledge Academy. Recently, Amit has authored a book titled “Riding the Roller Coaster – Lessons from Financial Market Cycles We Repeatedly Forget”. The views expressed are his personal opinions.