Many investors have debated the long-term benefits of dollar-cost averaging, even though they’re known for structured approaches. Investors wanted a strategy that allowed for regular investments with an aim to generate potential returns but could also adapt to market conditions—basically, a way to buy low and sell high. This led to the development of value averaging.
According to the Securities and Exchange Board of India, as a part of investor education, averaging is “The process of gradually buying more and more securities in a declining market (or selling in a rising market) in order to level out the purchase (or sale) price.” With this concept in mind, let’s delve deeper into value averaging and its unique approach to investment.
To understand value averaging better, one needs to first understand dollar-cost averaging.
The Concept of Dollar-Cost Averaging
Dollar-cost averaging (DCA) is an investment strategy where you regularly invest a fixed sum, like, say, for example, ₹5,000 every month, into a specific instrument. The approach is simple yet can be quite effective in the long run.
When prices drop, your fixed amount buys more units i.e., you intend to buy more units with the same ₹5,000. On the contrary, when high, you get fewer shares with the same amount of ₹5,000. Over time, this probably helps evens out the cost per unit i.e., averages the cost of buying, helping to manage market volatility.
In India, we call it Rupee Cost Averaging (RCA). It’s common in Systematic Investment Plans (SIPs). With SIPs, you invest regularly in a mutual fund. Here you buy more units when the Net Asset Value (NAV) is low and fewer units when costly. This method seeks to smoothen out market fluctuations.
RCA can be assumed to be well-suited for long-term financial goals like retirement. They encourage disciplined investing, reducing the urge to time the market which can be highly risky. While these methods don’t guarantee profits, they help you build wealth systematically.
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What is Value Averaging?
In RCA, you invest a fixed amount regularly. Value averaging (VA), however, is dynamic. Instead of investing a set amount, you adjust your investment to meet a target portfolio value, which may be inferred by the illustration mentioned below.
By that, if your portfolio falls short, you increase your investment to make up the difference. Conversely, if your portfolio exceeds the target, you reduce your investment to balance it out and maintain the desired growth trajectory.
For example, let’s assume that your target portfolio value is to increase by ₹10,000 every month, and currently, your portfolio is worth ₹100,000. By the end of this month, your portfolio value has increased to ₹104,000. Then, in this case, you will need to invest only ₹6,000. If your portfolio value would have been ₹112,000, then you would have to sell investments worth ₹2,000 to reach your target portfolio value for the month.
Source: Nasdaq
This method suits investors who want a structured approach to achieve a financial goal within a specific timeframe. It helps instil financial discipline, steering clear of rash decisions caused by market highs and lows.
Why pick value averaging? It is argued that it helps reduce the risk of overexposure during financial market bubbles. By adding more funds during market downturns, it may help your portfolio recover faster. Having cash reserves ready is essential for making these adjustments.
Monitoring is key. Keep a close watch on your folio’s value & tweak your investments as needed. This may seem demanding, but it has the potential to maximise the benefits of market movements, letting you buy more when prices are down and less when they rise.
Value averaging deals with market volatility effectively. In rising markets, it prevents you from overcommitting. When prices fall, it positions you to buy at lower prices, setting up for potential gains when the market rebounds.
How Does the Value Averaging Strategy Work?
Assume an investor investing in a Mid Cap Fund, aiming to grow an investment by ₹10,000 each month. The investor aims to have the portfolio value reach ₹40,000 by the end of the 4 months, starting with an initial investment of ₹10,000. The fund manager is responsible for managing the Scheme to help achieve this goal.
Here’s how value averaging works in this hypothetical scenario:
| Month | Market Price (₹) | Amount Required (₹) | Units Purchased | Units Owned | Amount Invested During Period (₹) |
| 1 | 10 | 10,000 | 1,000 | 1,000 | 10,000 |
| 2 | 12.5 | 20,000 | 600 | 1,600 | 7,500 |
| 3 | 8 | 30,000 | 2,150 | 3,750 | 17,200 |
| 4 | 10 | 40,000 | 250 | 4,000 | 2,500 |
When the market surges:
From the above hypothetical example we may infer that in the first month, with an investment of ₹10,000 at ₹10 per unit, you acquire 1,000 units. The following month sees the market price rise to ₹12.5. To hit your target value of ₹20,000, you only need to add ₹7,500 more since your initial 1000 units are now worth ₹12,500. This extra investment nets you 600 more units, raising your total to 1,600 units.
When the market declines:
From the above illustration we can say that by the third month, the market price declines to ₹8 per unit from ₹12.5. To achieve a folio value of ₹30,000, you have to add ₹17,200 more. This buys you 2,150 units, summing up your holdings to 3,750 units. Investing more during a market dip means you get units at a bargain, setting the stage for substantial gains when the market rebounds.
Now, RCA is in the same hypothetical scenario.
| Month | Market Price (₹) | Amount Invested (₹) | Units Purchased | Units Owned |
| 1 | 10 | 10,000 | 1,000 | 1,000 |
| 2 | 12.5 | 10,000 | 800 | 1,800 |
| 3 | 8 | 10,000 | 1,250 | 3,050 |
| 4 | 10 | 10,000 | 1,000 | 4,050 |
In summary
| (₹) | Average Cost | Total Cost | Current Value | Current Gain |
| RCA | 9.88 | 40,000 | 40,500 | 500 |
| VA | 9.3 | 37,200 | 40,000 | 2,800 |
RCA shows an average cost of ₹9.88 per share, with a total investment of ₹40,000, resulting in a current gain of ₹500. In comparison, VA has a lower average cost of ₹9.30 per share, a total investment of ₹37,200, and a higher current gain of ₹2,800.
In both market conditions, value averaging seeks to adjust the investment amount based on how the market is performing. This can result in a lower average cost per unit. As a result, the overall performance of the portfolio may improve. On the other hand, RCA aims to involve investing a fixed amount regularly, no matter how the market is moving.
Why Does Value Averaging Investment Plan Stand Out?
- Customised Investment Approach: Value averaging offers a flexible strategy. Unlike fixed-sum investing, it adjusts contributions based on portfolio performance. If the portfolio dips, you invest more. If it rises, you invest less. This method seeks to keep you aligned with your targets.
- Responsive to Market Conditions: Markets are unpredictable. Value averaging thrives on this unpredictability. Suppose your folio value falls short of the target, you invest more to make up the difference. Conversely, if it exceeds the target, you scale back your investment. This dynamic adjustment seeks to capitalise on market volatility.
- Cost Efficiency: When prices fall, you buy more shares, lowering the average cost per share. As prices rise, you buy fewer shares. This strategy of buying more during downturns and less during peaks helps position your portfolio for potential growth. Over time, this method may result in lower costs and potential returns. As markets recover, the lower-priced shares you purchased during the downturn may contribute to increasing your overall potential returns.
- Risk Mitigation: Spreading investments always has its perks. Instead of a lump sum at potentially the wrong time, gradual investments may smooth out market fluctuations, reducing the impact of volatility and thereby aiming to manage risk.
- Discipline and Corpus Building: The act encourages disciplined investing by making you adjust contributions based on market conditions. This method keeps you focused and prevents hasty decisions. By aiming for a fixed portfolio value it helps progress and seeks scaling of investment corpus towards your financial goals.
Potential Pitfalls of Value Averaging Strategy
- Missing Out on Rally: In the bullish phase, the strategy might aim at buying less, potentially missing out on significant gains. For example, during a bull run, investing less means not fully capitalising on rising prices.
- Frequent Funding Requirements: Maintaining target values often demands more frequent contributions. This can strain your finances, especially if surplus cash isn’t readily available. The need for regular funding can be a significant burden.
- Complex Calculations: Value averaging involves intricate calculations to determine the target portfolio value.
- Demand for Active Oversight: Unlike RCA, which is straightforward, value averaging requires constant attention. You need to adjust contributions based on market performance, which can lead to emotional decisions and biases.
- Higher Expenses: Frequent adjustments might lead to higher expenses. For instance, buying more shares during market dips and selling during rises can incur transaction costs. These expenses, coupled with potential tax implications like short-term or long-term capital gain taxes, can reduce your potential returns.
- Dependency on Market Prediction: Value averaging relies heavily on predicting market trends. Misjudging market movements can derail the strategy. This reliance on forecasting can be challenging, especially in volatile markets.
- Challenges in Downturns: During recessions, increasing investments can be tough. For instance, when incomes drop, finding extra funds to invest can be challenging. This aspect makes the strategy difficult to implement during economic downturns.
Head-to-Head: Rupee-Cost vs. Value Averaging
| Aspect | RCA | VA |
| Investment Amount | Fixed amount regularly | Varies based on portfolio performance |
| Market Adaptation | Not adaptive, invests without adjustments. | Adapts to market conditions, investing more in dips |
| Complexity | Simple and straightforward | Requires complex calculations |
| Management | Low maintenance, set-and-forget | High maintenance, needs active oversight |
| Cost Efficiency | May buy at high prices during peaks | Aims to buy low and sell high |
| Trading Frequency | Minimal | Can lead to overtrading |
| Funding Requirements | Regular, fixed contributions | Variable, may need more frequent funds |
| Opportunity Cost | Less likely to miss probable opportunities | May miss gains in a rising market |
| Risk Mitigation | Spreads risk over time | Adjusts contributions to manage risk |
To Sum Up
Value averaging is a sophisticated method requiring active management and market knowledge. It isn’t as straightforward as Rupee-cost averaging, which may suit the common investor. Although the potential returns from value averaging are debated, it might attract those who like to navigate market fluctuations themselves. Your choice depends on your investment style and goals.
Frequently Asked Questions
What is the meaning of value averaging?
Value averaging is an investment strategy. You adjust your investments based on portfolio performance. When the market drops, you invest more. When it rises, you invest less. This way, you buy more shares at lower prices. It helps manage risks and aim for better returns. Value averaging keeps your investments aligned with your financial goals.
Is value averaging a good idea?
Yes, value averaging may be a good idea. It helps you buy more when prices are low. You invest less when prices are high. It aims for potential returns over time. But it needs regular monitoring. It’s not as simple as other methods. If you can manage it, value averaging could be beneficial. Hence, it’s always advisable to consult your financial advisor before investing.
What is value averaging in SIP?
Value averaging in SIP means adjusting how much you invest based on your target portfolio value. If your portfolio is below the target, you invest more. If it’s above, you invest less. Say if your goal is ₹10,000 & your portfolio is at ₹8,000, you add ₹2,000. If it’s ₹12,000, you invest less or nothing. This helps buy more when prices are low. It needs regular checking. It’s like tweaking your savings to stay on track.
Is value averaging an investable strategy compared to DCA?
Value averaging might be seen as one of the investable strategies as compared to DCA. With value averaging, you change how much you invest based on market performance. You invest more when prices drop and less when they rise. This approach can help you buy more shares at lower prices. It aims for possible growth. However, it requires more attention and adjustments. Some find it more complex than DCA. It depends on how much effort you want to put into managing your investments.