Equity Investing: Know how value averaging investment works

Value averaging investment plan (VIP) is similar to its more popular cousin, dollar cost averaging, which is widely known as systematic investment plans (SIP). The concept of value averaging investment plan was first introduced in the year 1988 by former Harvard professor Edelson. It follows the conventional investment philosophy of buying at low and selling at high.

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What is VIP?
Under this investment philosophy, an investor determines his goal—the final amount or corpus which he wants to achieve during the holding period and invests accordingly with the market movement. Accordingly, a value path is created which directs the investor on what the value of the portfolio should be at any given point of time.
Investors make sure that the actual portfolio value is as close as possible to the value path. If the portfolio value is behind the value path, then investors need to invest more money. This is a more of a formula driven approach and accordingly, the investor buys higher at low prices and may not buy at all when prices are high. Thus, this method is very much different from the popular and widely used SIPs.

SIP vs VIP
SIP follows the rupee cost averaging and accordingly the investor invests a pre-defined amount every month/quarter irrespective of market movement. So, if market goes down the investor ends up buying more units but may not be investing a higher amount.

Let us understand the mechanics of SIP and VIP by assuming a monthly investment of Rs 10,000 in both the plans with the expected rate of return at 1% per month. Accordingly, by the time the second instalment is due, the invested value should grow to Rs 10,100. But, owing to market ups and downs the actual value is Rs 9,500. The SIP investor will continue with the Rs 10,000 investment, the VIP investor will compensate for the deficit of Rs 600 (Rs 10,100 minus Rs 9,500) and make an investment of Rs 10,600. By the third month, the first two instalments are expected to reach Rs 20,301.

Let us suppose the market goes up by 4% during the second month and invested value is actually Rs 20,904. Since the current value is higher than the targeted value, investment for the month will be reduced by Rs 603 (i.e. Rs 20,904 – Rs 20,301) and the VIP for the month will be Rs 9,397. In VIP, this process is followed month after month till you reach the goal date. But, SIP will continue to invest Rs 10,000 every month irrespective of the current market value of the portfolio.

Advantages of VIP
It mandates the investors to start with the end goal in mind and even allows the investors to sell if the market conditions are favourable. Under this, it is possible to adjust the end goal if the need arises. Further, factors such as market returns, inflation can be factored in while creating the value path.

With SIP, the investment amount is fixed for every month but the value of the portfolio is higher than the investments made. With VIP, the value of the portfolio is fixed. The cost of investments is usually lower than the value of the portfolio. To conclude, both the concepts works well in various market conditions and protect the investors from the risk associated with market volatility.

The writer is a professor of finance & accounting, IIM Tiruchirappalli

VIP advantages
Under VIP, an investor determines the final corpus he wants to achieve during the holding period and invests in accordance with the market movement
Factors such as market returns, inflation can be factored in while creating the value path
With VIP, the value of the portfolio is fixed. The cost of investments is usually lower than the value of the portfolio
The investor buys more at low prices and may not buy at all when prices are high