What Does Value Averaging Mean?
VIP is an averaging technique aimed at achieving a defined return, irrespective of a market movement. Investor invests more when markets are down and invests less when markets move up. The investor keeps a target long-term rate of interest in mind and applies the same while ascertaining the investment amount per month.
It works similar to the traditional Systematic investing plan (SIP) in that they both involve monthly investments in a particular investment instrument, Eg. Mutual fund, Stocks etc. However, the important difference from the investor’s perspective is that in VIP, the monthly deductions could vary month over month while in SIP, the monthly deductions remain constant.
How value cost averaging investing works:
Let us assume an investor who intends to make 15% per annum on his portfolio. He invests Rs 10,000 per month. At the end of the first month, he would see if his first installment has earned 1.25%. If the value of the first installment is more than that, then the next installment is less than Rs 10,000 to the extent of the surplus in the portfolio.
If the value of the portfolio is short of the desired level of portfolio, he will invest an amount (more than Rs 10,000) to match the desired level.
Let’s take One More Example to get more Clarity:
Suppose you want Rs 1,000 added to your equity mutual fund every month and you start with investing Rs 1,000. Now at the end of first month the value of your fund becomes Rs 1100. So now you need to invest only Rs 900 (1000-100) to make the investment worth Rs 2000. In the following month the value of investment reduces to Rs 1800 due to correction in the market, so you need to invest Rs 1200 (3000 – 1200) to make the amount to target amount of Rs 3000.
So what happens that you invest more when the prices fall and invest less when they rise? Like in the first month when the market rose you bought units with Rs 900 only while when the market corrected next month you invested Rs 1200. In other words, you buy more (units) when the prices are low and you end up investing less (buying less units) when the markets peak.
Value Averaging – Pros
- VIP plan out-performed the comparable SIP plan by 1.6% CAGR.
- Invests more rupee amount when markets are lower and less when markets are higher.
- Investment Returns are Pre decided Hence Investor Keep on Moving and adjusting the portfolio to get the desired results.
- Lower cost of acquisition in most scenarios as compared to SIP.
- Sum you invest each month will be highly unpredictable, Difficult for a Salaried Employee
- In long term and constantly falling markets the investment amount may increase much beyond the investor’s cash flow.
- Misses the opportunity of already being fully invested when a large market upswing occurs.