SIP or Value Averaging - What is the right way to go?

Cost Averaging/SIP and Value Averaging are perhaps the two most talked about investment approaches with regards Mutual Fund investments.

Most people have knowledge about Cost Averaging AKA SIP but Value Averaging is not well known in India.

In this article, we will go through these two approaches and compare them.

Let’s talk about Cost Averaging first

Cost Averaging also known as SIP

This elementary investment method is about investing a fixed sum at regular intervals – more than often monthly.

The reason behind this approach is help investors catch different market levels.

Assumptions of SIP

1. Timing the market is a fruitless exercise. Despite having rewards in timing the market, they do not remunerate the investor for the added effort.
2. The market will always be at a higher level in the long run.
3. While doing an SIP, the investor will make regular investments of fixed sum to average the cost price.

Therefore, as investors there are lot fewer things to trouble yourself with, when you do cost averaging or SIP. Your only thing you have to think about is whether you can invest a fixed sum on a monthly basis.

There are two sides to every coin. Likewise there are advantages and disadvantages of SIP

Advantages of SIP

1. You have a regular monthly salary and regular monthly investment, which means you are saving regularly from your monthly income.
2. An investor doesn’t have to worry about market timings. There is no additional effort required to wait for the best time to invest and divest. 

Disadvantages of SIP

1. Without choosing the right asset allocation, an SIP doesn’t actually reduce negative returns.
2. SIP is favourable for passive investors, where the investor doesn’t have to constantly check on cash inflow and outflow. But for active investors, SIP is not a good option.

• Cost averaging makes sense only if the investment is made for a long period of time.

Let’s understand SIP better with an example

Referring the table above, an investment of Rs5000 is made in a particular fund on a regular basis at the beginning of each month in 2012, total investment sums up to Rs60,000 at various NAVs. The average NAV is 10.712

SIP helps you to buy units at an average price of 10.712.

As an investor you don’t have to infuse a lump sum amount in one go. SIP takes care of your monthly savings and it also works for you XIRR wise. It helps you purchase units at an average price and lowers the risk of buying units at a premium price.

Value Averaging

There is not much difference between value and cost averaging. The only place where value averaging differs from cost averaging is

When you consider cost averaging, a fixed amount is invested on a regular basis, mostly monthly.

We will think of a lump-sum investment that follows value averaging.

Let’s assume Mrs Anand made an investment of Rs.5,00,000 in 2011 towards a which is due in 5 years. The required corpus after 5 years is Rs.8,00,000. This means the required rate of return is roughly 10%.

The above figures have to be met every year in order to achieve the set target

But let’s say that this doesn’t happen. We know that mutual fund investments do not have a fixed return rate like the fixed deposits

Expected rate of return on mutual fund investments vary unlike the fixed deposit. Rate of return on fixed deposit is well known in advance. Returns on fixed deposits do  not  fluctuate.

Value averaging investments focuses on having regular targets and also requires a regular check on the growth of investments.  

Let’s look at the example below:

Example of Value Averaging

In the above table, we add an assumption column- Actual Investment Value. This is the actual year-on-year progress of the investment amount and can be easily contrasted with the ideal investment value.

In the first year, expected growth of the portfolio should be at 10%, which will amount to 5.5 lakhs by the end of the year. But here the portfolio return isn’t upto the mark. It has a deficit of 20,000 than expected return.

Since there is negative figure, the amount should be added to the portfolio to achieve the target by the end of 5 years.

Value averaging basically tells us that the difference should be either invested or redeemed.

Assumptions of Value Averaging

1. A target for the financial goal must be set and achieved.
2. When the investor invests or redeems his money from value averaging portfolio, it is necessary for the investor to have surplus to invest anytime and other investments, if there is redemption.

Pros of Value Averaging

1. If you stick to value averaging, it is highly possible that you reach your financial goal before the set timeline.
2. Units can be purchased when the markets are down and sold when the markets are high.

Cons of Value Averaging

1. When it comes to value averaging, an investor must have surplus cash to infuse at the right timing. Let’s assume, it’s a good time to invest in the markets but the investor is not having any surplus cash. It misses the opportunity of a good buy. Similarly, the investor is having surplus to invest but it is buying at a higher price. Either ways the investor is on the fall side.
2. An investor must also be prepared for unexpected event like the market crash. Supposedly, an investor has invested certain amount towards a financial goal. Due to market crash, his investment is eroded. During such scenarios, he investor must be able to invest to compensate the loss in order to fulfil his goal. Sometimes this might not be possible.

Conclusion

Cost Averaging and Value Averaging are both work in their own ways.

Cost averaging makes work easier for someone who can invest a fixed sum on a regular basis, value averaging is for investors with surplus cash and alternative investment options.

In value averaging, possibility of reaching your goal is higher when compared to cost averaging. In cost averaging, fulfilling your goal depends on your investment returns when compared to expected return.

The best time to invest in equity is when the valuations are down and in debt when equity markets look expensive.

-Ridhi Sethia