Value averaging: Rule-based approach to round-trip investment

Many investors use Systematic Investment Plan (SIP) offered by asset management firms to build their portfolios. We discussed in this column last year why SIPs are behaviourally optimal. During the last 12 months, however, investors seemed to have faced certain issues with SIPs.

This article discusses one such issue. It then explains value averaging, a rule-based approach to round-trip investment that enables investors moderate this issue associated with SIPs.

Reinvestment regret

Suppose a person decides to invest Rs 10,000 every month in an index fund. As the Net Asset Value (NAV) increases, the number of units that an investor can buy for Rs 10,000 decreases. This appears to be a problem for some investors, as fewer units mean lesser upside participation.

A greater problem, however, is in taking profits and reinvesting the amount in a wobbly market, as has been the case in the last 12 months. The reason is that SIP concentrates only on investing, not on taking profits. For that, investors have to set up Systematic Withdrawal Plan (SWP). An SWP is appropriate for retiree-investors who take profits to consume cash flows.

Non-retiree investors have to decide when to move the cash back into the assets. The problem is that wrong market timing would cause regret, leading to an aversion to equity investments. It is, therefore, important to set-up rule-based approach to round-trip investing. Value averaging is one such approach.

Value Averaging

Consider a person who wants to invest Rs 10,000 every month. The investor will initially buy 1,000 units in index fund, assuming NAV of Rs 10 a unit.

If the NAV moves to Rs 14 in the second month, the investor need not buy 715 units (Rs 10,000 divided by Rs 14) as in the case of an SIP. Instead, the computation works this way: the portfolio has Rs 20,000- 10,000 in index funds purchased the previous month and Rs 10,000 cash allocated for current month`s purchases. At an NAV of Rs 14 a unit, the portfolio can hold 1,429 units. As it already has 1,000 units, the investor has to buy only 429 units, using Rs 6,006.

Suppose the NAV climbs to Rs 25 the month after. With another Rs 10,000 scheduled for that month`s investment, the total portfolio value would now be Rs 30,000. At an NAV of Rs 25, the portfolio ought to have 1,200 units. And it already has 1,429 units. The investor has to, hence, sell 229 units.

Side pocket

But what if the NAV declines sharply to, say, Rs 20 the following month? At Rs 40,000, the portfolio ought to have 2,000 units whereas it only has 1,200 units. The investor now has to buy 800 units, which amounts to Rs 16,000. The scheduled monthly investment is only Rs 10,000. From where will the investor get another Rs 6,000?

Enter the side pocket account. An investor should typically operate a money market fund along with the investment account. During months where the investment account sells units, the proceeds will be swept to the money market fund — the side pocket. This side pocket will provide cash during months when investments higher than the scheduled contributions are required.

It is important to understand that the side pocket account has zero risk-tolerance. The objective is to protect capital, earn cash returns and finance shortfalls in the investment account.

Value averaging essentially sells units when prices climb sharply and buys more when prices fall sharply. This approach is optimal when prices are volatile and not trending. It can be easily applied on ETFs, as short-term selling will attract exit loads on open-end funds.

The approach can be useful within the core-satellite framework. It can be especially applied for creating retirement portfolios. Investors require expected return on investment, the investment horizon and the monthly contributions to set-up an optimal value-averaging plan.

Four basic habits for a better financial health!

> Save before you spend
> Invest what you save
> Protect what you invest
> Analyze where you spend

These are the only 4 very basic things that you need to always remember to make sure your financial health is taken care of you. And what`s better - once you are in this habit, the process will automatically take care of your personal finance.

Save before your spend - Analyze your monthly income and make sure you have proper commitment for savings. This saving could be in any form - Idea is to get into a habit.

Invest what you save - Tax saving mutual funds, fixed deposits (FD), bonds, PPF etc. please consult your advisor before investing in any of the options available in the market. All depends on the kind of commitment you would like to get into. A tax saving mutual fund will have a minimum of 3 years lock in period. A PPF account would have a 15 years lock in and FDs have a variety of options starting from a couple of days to many years. Many leading banks in India provide you with an option to make an FD account online.

Protect yourself and your family from the uncertainties of life. Make sure you have a proper life insurance policy which should be a minimum multiple of 10 of your annual salary (in my opinion). Also, make sure you have a health insurance to cover any accidents in life. Generally this health insurance is taken care of by the company where you are employed, if not then make sure you get yourself at least the basic health policy.

Analyze your spending - How often do you check how much you have spent on your groceries? The number of times you went to your favorite fast food joint? How much did you spend on fuel this month as compared to the last? These are just a few questions which need to be answered with proper analysis. Spreadsheet or personal finance software can help you do a proper analysis. Track your credit card usage and make sure you pay the outstanding on time, late fees payment is definitely an expense that can be avoided by having timely alerts reaching your inbox or your mobile phone. Also see to it that you hold the right kind of credit card, there are many options available in India which provides cash back facility or have a very good loyalty point system that can be used to buy other important things in your life!

These four points may sound simple and as a matter of fact they are simple! All that is required is a habit of a regular savings and investing in the right kind of instruments, getting insured and yes, not forgetting to analyze your spending pattern! Please contact a professional financial advisor to get a better guidance on the subject matter.
Kunnath Santhosh is a co-founder and director, Perfios software Solutions. Perfios offers an online personal finance software solution that provides a 360 degree view of one`s personal finance with very little manual effort.

MITUL SHAH

Financial Planning Go for SIP in diversified equity funds

I am a doctor and I have two children aged 18 and 20 years. I was told that if I can invest Rs 10,000 a month for at least 25 to 30 years, I can give them a lump sum of Rs 10 crore due to compounding of interest. Is this correct? If this is true, where should I invest? Should I consider a SIP or MIP or a bank deposit? Are they the same?

Dr Rajesh Kumar, AHMEDABAD.

Accumulating a lump-sum of Rs 10 crore with savings of just Rs 10,000 a month is not an easy task.

Your investment would have to grow at nearly 17% annually to fetch you a lump-sum of Rs 10 crore at the end of 30 years, if you invest just Rs 10,000 a month.

Now, this kind of a return is possible if you stick purely to stocks or equity mutual funds, but one cannot bet on it. Over the last ten years, for instance, the Sensex has managed just a shade over a 13% annual return — nowhere near 17%!

Higher monthly savings

Therefore, assuming you can take the risks of investing in pure equity funds, we would suggest you prepare to invest for a 30-year time frame and manage a higher monthly savings of Rs 15,000 towards this lump-sum.

A monthly investment of Rs 15,000 over 30 years could fetch you a lump-sum of Rs 10.5 crore at the end of 30 years, if it grows at 15% compounded annually.

A 15% return is not an unrealistic assumption to make when you invest in stocks or equity funds.

There have been times in the past when equity funds have delivered a 25 or 30% annual return. Any repeat of such phases could lead to achieving your return target earlier than expected. Therefore, do begin investing and don`t hesitate to cash out early if you hit your targeted lumpsum earlier than the 30 years you planned for!

The accompanying table should give you an idea of the lumpsum you can accumulate by investing in different avenues for 30 years. Now to the question of where you should invest. With your annual return target set at a fairly stiff 15%, you may need to invest the sum of Rs 15,000 in an equity or at best a balanced fund. These funds would see their NAVs swing substantially up and down with stock market movements, but you would need to hold on through the market ups and downs over a 30-year period to achieve your target.

You should go in for a Systematic Investment Plan (SIP) in two or three diversified equity funds with a good track record. Our suggestions would be: Benchmark S&P 500 Fund, DSP BR Top 100, HDFC Top 200 and Franklin India Bluechip Fund. Opt for the `Growth plan` to reap the full benefits of compounding, especially as you have a long horizon at your disposal.

A Monthly Income Plan (MIP) would not suit your purposes, as they are designed mainly to generate regular income for those seeking a pension-like payment. MIPs invest 80% or more of their portfolio in debt instruments with a small equity exposure of 10-15%. They are quite unlikely to manage the 15% annual return that you require. Investing in a MIP or a bank deposit would be much safer certainly, but doing this cannot fetch you anything close to the lumpsum of Rs 10 crore that you are aiming for, in 30 years.

MITUL SHAH

SHORT TERM DELIVERY CALLS

Cairn India Ltd:
This counter is trading at around 297 levels. We recommend a buy call with a target of Rs.372.


Biocon Ltd.:
Short term traders and investors are advised to buy and hold for a target of Rs.350. Strong fundamental and business arguments, competition scenario favours the company.


Fortis Healthcare Ltd.:
After its recent acquisition in Singapore, this company will become Asia's second largest hospital chain. Moreover Ranbaxy Group promoters at helm will drive PE expansion by big investors wanting to invest with such a promoter leadership business.
Buy for a target of 173-178 for short term and 212+ for mid term. Purely Bull market call.


Tata Power Company Ltd:
This is comparatively a low volatility counter. Sudden 2-3 consecutive days spurt make it rise 10-15%. Also slides with same frequency. Seems to be building a strong base and narrowing consolidation range and giving way to technical break outs.
Buy with a target price of Rs.1395 and 1440.
All calls are based on fundamental, technical and other factoral analysis.
For more and regular calls Contact our Research Team on 09879586722.