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Foundations

Value Cost Averaging

Happy New Year everyone!

I’ll start this year with an investment concept called Value Cost Averaging (VCA). This is a regular investment strategy which allows you to allocate money to an investment avenue (like a mutual fund) every month. The funda behind value averaging is: You don’t put a fixed amount of money every month. You expect a certain return and you put in only as much money that will match that return.

For instance let us say you have a target of 15% return annually, and decide to invest approximately Rs. 5000 a month. That means money should grow like this:

That means after each month you will evaluate how much your investment is worth, and compare that to where you should be in the next month. You will then invest the difference.

Example: If your fund value at the end of month three is Rs. 16,000, and in the fourth month you need to be at Rs. 20,378 – you will invest only Rs. 4,378 (the difference).

VCA is a very interesting concept and is very less used because most mutual funds don’t encourage it as much as SIP (Systematic Investment Plan, a fixed amount invested each month). In the last year, VCA seems to have beaten SIP in many funds – I have collated data for one fund, HDFC top 200.
This spreadsheet contains all details. Notes:

  • I have accounted for entry loads of 2.25%
  • Any excess cash in the VCA model will be invested in a debt fund at 6%. The “VCA+Cash” model gives you a comparison of returns on the same amount invested as the SIP.
  • The gains are as of 1 January 2007 (not including any investment in Jan 2007).

Results:

VCA has done better on all months, and with the Cash model it has beaten SIP by about 1% over the year. It will be interesting to compare other funds based on VCA and SIP returns, but my guess is that VCA model will prevail.

What is this cash thing?
VCA in a growing market involves a lot lesser investment. You’ll notice that in pure VCA, you had invested only Rs. 53,741 in the fund, versus Rs. 60,000 in SIP. That means even if you had Rs. 5000 free every month to invest, you had to invest lesser and lesser every month as the market went up!

The remaining money can perhaps be put into a liquid fund or a debt fund because you may need it when the market goes down (because then more money than Rs. 5,000 will be needed). I am assuming that such a cash investment gives you about 6% p.a., and the total returns at the end of the year are noted in “VCA+Cash”.

How to do this VCA thing?
No mutual fund allows you to invest in a VCA model. That is largely because the amount invested every month varies; with SIP the amount is constant. I think it’s an issue of logistics: Since most people invest using cheques, the funds know it’s a logistic problem to get cheques every month for different amounts. (With SIP, the amount is the same so they take the cheques upfront.)

Of course, they can solve that problem by using ECS instructions instead, but funds are not yet doing it. So you have to do VCA yourself, manually.

Most funds take investments in multiples of Rs. 100, so you will need to adjust your strategy a little bit – when you need to invest Rs. 4,568 invest Rs. 4,600 instead. (Round up to the next higher hundred).

Update: If you want to view the spreadsheet, and download it as an excel file or such, click here.

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