September 17, 2009

Value averaging Investment Plan (VIP), a new approach towards Investing...

Asset Management companies (AMCs) often come up with new ideas to attract investors. The quest for an investment tool that helps investors achieve the dream of good returns on their investments with efficient management of risk has given birth to the concept of Value Averaging.

What is Value Averaging?

The idea of value averaging was first developed by a former Harvard University professor. Value averaging is a strategy that allows an investor to incrementally increase the value of the portfolio through the addition of a set amount of assets rather than relying on the existing components of the portfolio to achieve growth. This approach follows a particular formula for this and helps to shield the investors from the possible decline in the total value of the portfolio due to fluctuations in the market. Unlike the more common practice of rupee cost averaging, value averaging also includes the projected rate of return as part of the formula and projections.

Since value averaging is involved with making informed decisions based on certain criteria, this investment method is more structured than any other random investing style. This method helps the investor to be fully aware of the volatility for mutual funds and other securities that are under consideration and thus act accordingly. From this perspective, the systematic approach that is pertinent to value averaging helps to limit the amount of risk that the investor may incur as a result of the transaction.

The method of value averaging includes projecting the expected rate of return on a given investment and determining when the investor will want the maturity or would like to sell the security. We have then to consider periods when the security will perform above expectations and periods when it will underperform. During the fluctuations, the investor will adjust buying and selling accordingly, so that the anticipated return can remain more or less constant. In this way the investor will be able to project when the final average return will be achieved; and thus can plan when to sell off the security.

Value averaging Investment Plan (VIP)

Under the VIP, investors contribute to their portfolios in such a way that the portfolio balance increases by an amount calculated by a formula-based technique, regardless of the market fluctuations. As a result, when the market declines, the investors contribute more and when the market goes up, the investor contributes less. This is in contrast to Systematic Investment Plans (SIPs) which are based on Rupee Cost Averaging, requiring a fixed investment at each period. The VIP takes into consideration the expected rate of return of your investment.

Why Value averaging the investments?

The age-old formula - ‘to buy cheap and sell dear’ still inspires many investors. The crux of value averaging is simple: It is difficult to identify the top and bottom of market. Varying the amount of investment with time can help investors.

Let us understand this concept with an example. Suppose you want Rs 2,000 added to your equity mutual fund every month and you start with investing Rs 2,000.

Let us assume that at the end of first month you find that the value of this investment has fallen to Rs 1800 due to a correction in the market. In that case, in the next month you will invest Rs 2,200 to ensure that you have Rs 4,000 in your fund. By the end of the second month, let us say, you find that the value of these units have gone up to Rs 4,200, then in the third month you will invest Rs 1800 only, taking the value of the units to Rs 6,000 (Value Averaged). Here you invest more when the prices fall and invest less when they rise. 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.

Because the risk is often minimized and the return is more or less reliable, value averaging is a great way for investors to methodically increase the value of their investments. In the above example, it’s recommended that one should invest Rs 200, which is not being invested in the third month due to a rising market, in a safe instrument or keep it in a savings bank account. The thing to keep in mind is that this money will be utilized when markets fall. After all, to get the best out of VIP one should have sufficient funds during a bear market.