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Thursday, September 24, 2009

About Cost averaging and Value averaging strategies

Following a strategy involving either Cost averaging or Value averaging can lead to significant wealth creation for most investors - specially if followed for a reasonable period of time. These are simple strategies, but require investing discipline.

Cost averaging

Let us say, you are able to save Rs 3000 per month from your income. If you are a novice investor, or, have not yet learned how to pick fundamentally strong stocks, choose an index fund or an index ETF (like Nifty BeES). More experienced investors can choose any of their favourite stocks.

Every month, without fail, buy Rs 3000 worth of index fund/ETF units (or any stock that you have chosen). When the market moves up (bull market), the number of units/shares you get to buy every month will get reduced. If the market moves down, the number of units/shares will be more.

So, if you buy 300 units of Rs 10 in the first month, and the next month the net asset value (NAV) of the unit is Rs 12 - you will buy 250 units. In the third month, if the NAV is Rs 15, you will buy 200 units.

This strategy is identical to the Systematic Investment Plan (SIP) touted as very effective for small investors by most fund houses. Though this is a no-brainer system that any one can follow, it has a drawback. It doesn't work so well in up or down trending markets.

Value averaging

This is a variation to the cost averaging concept, that requires more monitoring. Instead of investing a fixed amount every month, you buy according to a pre-determined value of your portfolio. Let us say, it is Rs 3000 per month.

As in the above example, you buy 300 units @ Rs 10. At the beginning of the second month, if the NAV has increased to Rs 12, then the value of your portfolio has become Rs 3600. Instead of investing Rs 3000, you will invest Rs 2400 - getting 200 units in return. Your total portfolio value becomes Rs 6000.

If at the beginning of the third month, the NAV is Rs 15, then your portfolio value is Rs 7500. So you'll invest only 100 units to reach your goal of Rs 9000 after 3 months. (The actual numbers - and the math - will not be so simple. An Excel spreadsheet should take care of the calculations.)

See the difference? In the Cost averaging (SIP) method, you buy 750 units in 3 months for Rs 9000. In the Value averaging method, you invest Rs 6900 to buy only 600 units. In other words, you invest less when the market is going up. The balance savings of Rs 2100 can be used when the market turns down (bear market).

What happens when the market goes down? Which method will be the better of the two? Why? Are there any drawbacks to the Value averaging strategy?

Ponder about these questions. And get back to me with your opinions and comments.


Sanjeev Bhatia said...

Dear Sir, The article, though brief, gives a fairly good idea about the two strategies. However, the VCA method is much more difficult to adopt because of few inherent difficulties... first, you have to know what future value you want, in other words, what financial goal you are aiming for and what amount is needed for that? Also, you have to calculate the monthly deposit required based on some return assumption. Then you have to work out the maths every month. But the biggest advantage is that you are almost 100% sure of meeting your goal because you will be varying your investments as per the returns. Theoretically, VCA should give better returns than SIP. I tried to do some modelling in spreadsheet but somehow the difference between the two didnot turn out to be of much significance. Maybe the calculations should be done on a longer time frame. Mentally though, I really feel VCA should be a better alternative.

it was interesting to note your recommending these strategies despite writing aginst SIP in an earlier article. SIP returns will always, always be less than lump sum investment in rising market. It is only in sideways and volatile markets that SIP works its wonders. The time period of 12 months in your earlier article was too short, and that too in one way bull market, to give advantage of SIP. However, had you continued them till date, the logic must have been clear by now. I feel for ordinary investor not having sufficient time, discipline and/or information to track & reasearch equity, SIP in Mutual Funds remains the easiest route to wealth creation.

I have found your articles excellent in content and depth. I have added your blog to my follower list. I am a CFP (Certified Financial Planner) based at Ludhiana and a recent entrant to blogosphere. (

Keep up the good work, Sir.

scorpio said...

Its good you brought this topic on averaging, but then when would you do the profit booking? I did like the last post which said do partial profit booking, so with averaging you should book profits as well. Again I avoid to average downwards - some bit of trader mentality, always add more when its trending in the direction of your trade. One doubt I had - so say the markets move down the very first month onwards and for the next 15 months, would I be adding more "money" when its falling down? Example - So month 1 I put 3000, next month my value is lower say 2000, so would I need to add more money - say 4000 Rs to make it equal to 6000?

Would it not cause much pain if you have got on investing at the top of the markets and every month are putting in more money and losing. Maybe a person may not have that much savings as well to put more money in the months ahead, but if you can add more money at lower levels - then you are rich :) I would get exhausted both mentally and financially :D

As Sanjeev mentions, your blog is a great place :)

SG Money Mind said...

People get tempted when the NAV's/stock prices rise. The more it rises, the more they start deviating from their original plan.

The bland SIP, coupled with some intelligent packaging like FT Dynamic PE Ratio Fund does work wonderfully for several people.

The product has its drawbacks. Still, it is lot better than some of the best balanced funds in the market.

S.Sujai Gangatharan said...

Good Article, it is not possible for a small retail investor to value average in downtrend like last year. But possible to cost average. But I think both strategies have enormous power if one do it in a disciplined manner & for long term.

Subhankar said...

@Sanjeev: Welcome to the blogosphere, and thanks for your comments.

I've suggested Value Averaging as an alternative to SIP (Cost averaging), because it gives better returns. You have already mentioned one advantage - that of meeting one's financial goals. The other big advantage is that it makes you invest more during bear markets.

Bear markets typically last about a quarter or a third of the time duration of a bull market. So your window of buying during a bear market is smaller. Small investors get caught up in the bull market hype and tend to buy at the later stages of a bull period and get stuck.

@scorpio: Appreciate your inputs, Ashish. You've hit the nail on the head about the major disadvantage of the Value averaging strategy.

As prices fall in a bear market, you will need to put in more and more money every month to maintain your total investment value. The amount to be invested may exceed your monthly savings.

That is why I suggest maximum investment in a PO MIS plan and in bank FDs with quarterly interest - so that a regular flow of cash can supplement your regular monthly income.

One should avoid averaging down - particularly in small caps. But averaging down on a TISCO or an ITC or a Glaxo may be the only way you make big profits from stalwart stocks.

@SGMM: No question about SIPs being the best investment vehicle for those investors who neither have the time nor the inclination to do a lot of research. The question is: how many maintain the discipline of investing over several bull and bear markets?

As mentioned above, bull markets tend to last longer than bear markets, so your average cost in a SIP keeps going higher in the long run - reducing returns.

A couple of balanced funds - HDFC Prudence and DSPBR Balanced - protected the down side reasonably well (falling much less than the Sensex). Haven't checked the fund you've mentioned.

After the huge hit that many funds took last year, a lot of capital protection and automatic profit booking funds are popping up of late. The Dividend Payout option that I choose in my fund holdings automatically takes care of 'profit booking'. It also provides periodic cash flows.

Subhankar said...

@Sujai: Small investors can follow the Value averaging strategy if regular monthly savings can be supplemented. Check out my response to scorpio's comment.

Small investors tend to jump into the stock market without testing the waters. I suggest young investors to first invest the maximum in PF/PPF scheme, followed by the PO MIS, and then only venture into the stock market.

Eswar Santhosh said...

Irrespective of everybody saying "Never Average Downwards", I find it to be a very useful tool. In these 5 years, including a bear market (without which I would not even use the term "experience"), averaging downwards has given me lot of winners. But, I have found several flaws within my strategy and not the same sort of averaging works with all stocks.

My observations are:

1) It always works in a good stock, not in "any" stock.

2) Most times, the vital thing is where you start averaging. Begin in the wrong range and you can average till zero and still lose money after a decade. Patience is the key. I have gaps of 2-3 years in some cases between "Buy"s.

In general, when you book part profits in such stocks, higher cost lots go out first resulting in sort of a "price wise comfort". With that, you typically can hold on to the remaining quantity for far longer periods.

Since this comment has already gone long, using another comment to comment on the blog post itself.

Eswar Santhosh said...

With VCA Vs SIP, I still find VCA to be Ok theoretically. Look at the following hypothetical sample. (Copy-paste from Excel does not work well. So, will present it in textual form)

* Consider a Hypothetical Fund which has a NAV of 15. Let's say, it decreases in NAV by 1 till the 8th month and then increases by 1 for 4 months (Total of 12 months. NAV goes down from 15 to 8 and then increases back to 12)

* SIP is Rs. 3,000 per month. VCA is also the same Rs. 3,000

* By the 8th month, where NAV is Rs. 8.0000, VCA would have required you to invest Rs. 5,333.33, which is nearly 78% higher than your SIP Amount.

* In VCA, by theory, your allocated amount should be placed separately. If you had invested only Rs. 1,800 out of it, you would need to preserve Rs. 1,200 in cold storage until required. Of course, this is true if you have started in a bull market and have saved that amount. But, if you instead start in a bear market, it would strain your savings. By the 8th month (NAV is at the lowest), you would have invested Rs. 31,817.85 vis-a-vis Rs. 24,000 at that point in SIP.

* But, watch the difference once the NAV starts going up. In SIP you still would be investing Rs. 3,000 per month. However, in VCA you would not need to invest a single paisa after the 8th month.

* Final returns after 12 months ->

-- NAV and hence bulk investment has returned a negative 20%

-- SIP has returned +11.07%

-- VCA returns +13.14%

* In the interim, returns from VCA do not fall behind SIP in returns even for a single month. The worst returns for Bulk, SIP and VCA (8th month) are -46.7%, -27.5% and -24.6% respectively.

* So, while VCA looks "cool" as far as using Excel and writing formulas is concerned, the maximum out-performance over SIP never crosses 3% (max: 2.9%) in our hypothetical MF.

Real world tests using Nifty BEES could be done later. But, I am in a hurry to get back to enjoying the reminder of the weekend :-)

SG Money Mind said...

Shubhankarji, Have a look at the fund which I mentioned. The fund is so bland, which is why it doesn't attract investors to it. It has 100 odd crores even though it is more than 5 years old. But it has a beautiful balancing strategy through which it has even outperformed the pure equity index like BSE Sensex hands down. Most of the time keep the emotion out of the investment, the investment will do better. The fund does that silently.

My feeling is, even if you do lump sum investment in this fund, it will still give you a better return. Do remember that people will have more money in hands when markets are doing well; which means the economy is doing well, which in turn leads to better salary or better bonus or better income in their own business. The lay man is not exactly wrong to invest more when the markets are doing well. It is not exactly his mistake :)

Subhankar said...

@Eswar: Averaging down is not a smart practice - unless you are very sure of the prospects of the company. I would only venture to do it with stocks that I've held for several years through bull and bear cycles.

Thanks for doing the hard work with the Excel VCA model. Since bull markets tend to last longer than bear markets, you may want to redo the exercise where the NAV goes up by Re 1 every month for 9 months, and loses Rs 1.50 every month for 3 months (retracing 50% of the gain). That would represent a full bull-bear cycle, where each model-month equals 6 calendar months.

@SGMM: You have piqued my interest. I'll definitely have a look at the FT fund. Thanks.

You've raised an interesting point about having disposable funds when the economy is doing better and the market has already gone up. You are supposed to invest when you have the money - regardless of the state of the economy or the stock market.

The solution to this conundrum lies in proper asset allocation. If the market looks overbought and ripe for a correction, invest in short-term fixed income or stay in cash. If the market looks reasonably priced, buy equity shares.

BruceR said...

Good article.

If you would like to learn more about Value Averaging visit

sriganeshh said...

dear sir,
value averaging is nothing but old concept of fixed percentage asset allocation method wherein u maintain certain % of absolute amount to the total in one asset class and keep regularly maintaining. In case % goes down, bring it back to the established levels by booking profits or withdrawing as the case may be.

Subhankar said...

Not quite, sriganeshh.

In value averaging, you go on investing over a period of time keeping the value of your investment at a fixed amount for each period (month, quarter, year). It has little to do with asset allocation and profit booking.

sriganeshh said...

dear sir,
my point is it is nothing but old genie in new bottle.In earlier concept also, u can invest regularly but the ratio in value terms has to be maintained. Please think it over and and am sure u will come up with new post on this..
in the weekend, if possible will try to post the working method


Subhankar said...

They are actually two different genies in the same investment bottle, Sri.

Please read my post: How to Reallocate your Assets (Oct 26, 2008).