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Concepts & Tutorials

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.

  • Anonymous says:

    >Deepak
    Another point you can mention is that if the current value is greater than the expected value during any month, the extra value can be booked as profit by selling the appropriate number of units. Then during that month no payment need be made.In this way profits can be periodically booked in case of oversold market conditions.Instead of assuming an expected return as target it is sufficient to keep the amount paid itself as the target like in an SIP. This will promise greater returns.
    Vikram

  • Anonymous says:

    >Hi Deepak,

    This rajiv from WATblog.com. I was just going through your blog its a great effort!
    I was just wondering whether you would be interested in being a part of a group blog.. something like WATblog but for financial content.
    I plan to setup such a blog and was looking for content contributors who are experienced.
    Do let me know if it interests you and also what would be your per post charges for blogging.


    Warm Regards,
    Rajiv Dingra
    rajiv.dingra@gmail.com

  • Prasanth says:

    >Deepak,

    An interesting idea. I read about VCA first in Money Today but your VCA + Cash twist is better.

    Regards,

    Prasanth

  • praveenhegde says:

    >Hi, Deepak,
    Is it possible to send the VCA calculation spreadsheet to me. I just want to amount as per my convineance ( there is no other purpose). I tried to build excel on my own but i am not able to do it full

    U can send it me to praveenhegde@ibsaf.org

    thanks

  • Deepak Shenoy says:

    >Okay I’ve set up collaboration on this spreadsheet.


    View this spreadsheet here
    . You can choose to export it to excel etc.

  • SRIPATHARAMAN says:

    >Dear Friend!

    Thanx a lot for ur blog on investments of mutual funds.

    I am a trained mutual fund adviser
    and do on behalf of my bankers.

    It is quite interesting!

    My email id is sripatharaman@gmail.com

    Thanx for ur nice advice….sir

    Have a nice day…..

  • Anonymous says:

    >Your final calculation on return is using wrong cells and that’s why you concluded that VCA+Cash beats SIP. If you use correct cells then SIP gets 19.23%, VCA gets 19.65% and VCA+cash gets 17.70%.

    If you think about this then it make sense, you invested part of your money in 6% debt fund which would have generated higher returns if invested via SIP.

    I have personally done VCA vs SIP exercise in past and here are my conclusions:
    1. VCA beats SIP in terms or % returns in both rising markets and declining markets.
    2. The difference in % return between VCA and SIP are directly proportional to standard deviation of the market or investment vehicle.
    3. If you account for “lost opportunity” on amount not invested when using VCA results in lower “absolute returns” for VCA as compared with SIP.

  • Deepak Shenoy says:

    >Anon: Could you tellme which cell is wrong? I think what you’re saying is SIP is higher, but I can’t seem to see how, though I’m happy to be corrected.

    Actually staying in 6% debt is better in a scenario where the NAV is volatile, as you can see in the example. If you consider a pure rising market, SIP will beat VCA+Cash and on a pure declining market, VCA+Cash will beat SIP. In a up/down market, VCA+Cash may have the advantage as it did here.

    The Lost Opportunity in VCA can be overridden by cash, which as I mention will go below SIP only in the case of a purely rising index. I don’t suppose the index will rise month on month (do you?) and even in this example, where only three reversing monts were noted, VCA+Cash beat SIP.

  • Deepak Shenoy says:

    >btw, view the formulas etc. at this URL

  • Anonymous says:

    >Deepak,
    I am not sure if you have considered here the fact that with SIP the entry load is less than doing it manually.
    – Explorer

  • TempleTree says:

    >Hi Deepak,

    I want to start using VCA approach in investing. I did lot of study on SIP and found that SIP have many deficits in the bull run since it does not have any in-built profit booking mechanism. Also, peoples incomes grow over the time so constant amount per month is not a valid assumption.

    My question is, what is the sensible rate of return to target? I am thinking of 20%. Higher means it demands lot more from you while the market is going down. Lower means, it makes most of the money lie in the money market in the bull run.

    Any thoughts?

    Thanks

  • Deepak Shenoy says:

    >Templetree: Uhem, 20% is extremely high. 12-13% is good if you can do it. I would simply say target risk-free return plus a few percentage points.

  • Anonymous says:

    >I think a max limit would have to be set for the max that could be added the position i.e.,if someone was VCA for 50 years & the market dropped 89% like between 1929 – 1932 the amount that would need to be added to the position would be to great for most to handle. I also think there should be a limit on the max position size that could be sold to let profits run. Any thoughts on thix?

  • kukku says:

    good to know about your self & webpage.
    kukku

  • Kapil Visht says:

    Added a blog which gives a good comparison between Value Cost Averaging And Rupee Cost Averaging investment strategies. The blog does have examples as to how VCA compares with RCA in different market conditions.
    Following is the link – http://vcavsrca.blogspot.in/
    Regards
    – Kapil Visht