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Value Averaging is Effective way of Creating Wealth



Equity investment is an art as well as a science. The selection of an underlying is an art and selecting the right strategy to participate is a science. Clients often ask us: 'How do I participate in equities? Markets are near all-time high. Should I invest now or wait for the markets to correct? There is a lot of uncertainty in the markets', etc. My reply to them is that equity markets are always going to be uncertain, that there will always be volatility. But that is why equities give higher returns than other asset classes. Play smartly and take the benefit of volatility.
The objective of every investor is to buy low and sell high or invest more when the markets are low and invest less when the markets are high. This often sounds simple but in reality it is practically impossible to time the market. To achieve the above objectives, I suggest the 'value averaging strategy', as it smartly plays out in different market conditions.


Let us first understand what value averaging is. It was developed by former Harvard University professor Michael E Edleson. The value averaging investment plan is a powerful investment concept that provides considerable safety from market volatility, discipline and reasonable guarantee of returns. It is an averaging technique where the portfolio's balance increases in a defined way irrespective of the market movement.


In a value averaging investment plan, the amount invested each month is not fixed, but varies with the fluctuations of the market. Investors have a target portfolio value that they desire over a certain period of time. With each passing month, the plan adjusts the next month's contribution as per the relative gain or fall of the portfolio value from the target portfolio value. When the market declines, the investor contributes more and when the market goes up, the investor contributes less. This way the anticipated return remains more or less constant for the investor.


To check the superiority of this logic, we back-tested the value averaging concept in three different market cycles, ie, a falling market, a flat market and a rising market. We have considered a three-year analysis for each market cycle. We assumed 15% as the target return from equity and set the formula accordingly. Let's evaluate the investment results in different strategies:

DURING THE GLOBAL CRISIS OF 2008:

For our analysis, we took the data for Nifty from December 31, 2007, when the Nifty was 6138. It fell all the way to 2524 on October 28, 2008 and come back to 6134 on December 31, 2010. So, there was in effect no returns from Nifty for three years. In the same time period, the value averaging concept (VAP) in Nifty generated an internal rate of return (IRR) of 25.34%, compared with the 0% CAGR return from a lump sum investment in Nifty and IRR of 23.86% from investments through a systematic investment plan (SIP).

FALLING MARKET ANALYSIS (TECH MELTDOWN):

For our analysis, we took data from January 31, 2000, when the Nifty was 1546 and fell all the way to 1041 as on January 31, 2003. Nifty lost 32% in the above period. If anybody would have employed the value averaging strategy for investment, the returns would have been -4.24% IRR as compared with -6.69% IRR through SIP and -12.33% CAGR in case of lump-sum investment.

RISING MARKET ANALYSIS (DREAM BULL RUN):

For our analysis, we took data from December 31, 2004, when the Nifty was 2008, to December 31, 2007, when it touched 6138, generating 195% absolute return, ie, 43.43% CAGR. But with the value averaging strategy (VAP), the IRR would have been 52.48%, and for SIP strategy, the IRR would have been 50.89%. In a constant rising market, the absolute returns from lump sum would look better.

CONCLUSION:

Value averaging as an investment strategy is superior to the systematic investment strategy as it combines the benefits of relative valuation due to market movements and a disciplined investment approach for averaging. In the current state of directionless market it makes sense to apply this investment strategy for allocation in equities. Just be patient and give more time to your investments.
 

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