Contrasting styles of investment

Value averaging may give better returns compared to sips, but it is complex for retail investors

It’s conventional wisdom: To get the best return from stock markets, buy when prices are low and sell when they appreciate. But for the common investor, it’s rarely possible, as the stock market does not travel just one way.

To protect returns from the mercurial markets, investors are conventionally advised to invest regularly through a systematic investment plan (SIP). The benefit of an SIP is straight; it averages out the cost of purchase by buying at different levels, thanks to the regular investment. This is also called rupee cost averaging.

Of late, many investors have shifted away from this strategy. This is apparent from the fact that new mutual fund products that book profits regularly have been an instant hit. If you compared SIP returns with lumpsum investment in the current rally, the latter has fared better. Even if you compare the past three-year data, you will see a majority of funds have yielded the same result. The fact, though, is that an SIP fares better over a longer period. Though, it cannot beat lumpsum investment if someone invests at the bottom of the market, which then keeps going up.

For investors who rate value buying above investing a fixed amount every month, there is an alternative strategy. It is called value averaging. This is a more evolved strategy than rupee cost averaging, or SIP. In this, you adjust or vary the amount invested to meet a prescribed target value of the portfolio.

SIP, on the other hand, is a strategy in which you invest a fixed rupee amount on a regular basis, usually monthly purchase of shares or units of mutual funds. When the share or your mutual fund's value falls, you buy slightly more shares or units of the fund for the fixed investment amount, and slightly fewer when the price goes up. In this manner, the investor lowers the average purchase cost. But in value averaging, the investor invests more when prices fall and less, or nil, when it gains.

VALUE AVERAGING AND FINANCIAL GOALS

Using this mechanism, a person can build his financial goal and be sure of attaining it, irrespective of returns from the market. Here’s how it’s done: rather than trying to attain a fixed monthly amount, the investor could fix a compounded annual target growth of his portfolio. So, if you want your portfolio to grow by 15 per cent year-on-year, you contribute in such a manner as to reach this percentage each month.

An example should make this clear. For starters, in the value averaging concept, the investor needs to set a target rate of growth of their portfolio.

That is, with a target rate of growth of portfolio of 15 per cent, you are planning to create a Rs 6 lakh corpus in 10 ten years for say, a car or initial down payment for a house in 10 years.

In the first month, you invest Rs 5,000. However, because the market has fallen by say, 10 per cent, your investment is worth Rs 4,500 at the end of month 1.

Whereas, given the pre-defined rate of growth, your investment should have been worth Rs 5,750. So in month 2, you will have to invest Rs 6,250. Similarly, if the market had gone up by say, 20 per cent (Rs 6,000) the investment required in month 2 would have been only Rs 4,750.

Similarly, over time, depending on the rate of return that has been pre-decided, the targeted sum can be achieved.

VALUE AVERAGING AND RUPEE AVERAGING

In most of the research conducted worldwide, value averaging has always fared better than investments through SIP, though marginally.

Benchmark Mutual Fund, that has an index fund wherein an investor may opt for the value averaging technique, has done research comparing returns from the two investing methods. For SIP, they studied what a fixed amount of Rs 2,000 would yield if invested in the S&P CNX 500 index. For value averaging, the mutual fund started with Rs 2,000 and kept the upper limit of investment to Rs 20,000. The portfolio growth was targeted at 15 per cent each year over 15 years. The result: the latter delivered 2.87 per cent more returns each year.

WHERE SIP SCORES

The main goal of value averaging is to acquire more shares when prices are falling and fewer shares when prices are rising. This happens in rupee cost averaging as well, but the effect is less pronounced, although both will closely resemble market returns over the same period.

The biggest potential pitfall with value averaging is that as an investor's asset base grows, the ability to fund shortfalls can become too large to keep up with. Many investors may not have the potential for funding this shortfall as they save for multiple goals at the same time.

One way around this problem is to allocate a portion of money in a liquid fund and rotate the money when markets fall. But this can have tax implications. Also, when you invest as per market conditions, experts believe the investor is indirectly timing the market.

SIP, on the other hand, is neutral to timing the market. The investor is aware of the monthly outgo and does not need to keep a track of market movements.

CONCLUSION

Value averaging, if done by the investor himself, has some glitches. This method is for investors who can manage unpredictable cash flows. This is because the amount of investment varies with the market condition.

Another financial expert says there is more risk in this mode of investing. "When you put in more money on market corrections, you are exposed more to equities, making this riskier," he said. It will do much better in a rising market, as the portfolio will have few problems in achieving the targeted growth.

To actually benefit from the method, a person will need to regularly invest over a long tenure, of at least eight-nine years. “Here, the person will complete an entire bull-and-bear cycle, to average the value of his purchase,” said an investment adviser.