The SIP commonly employs EMIs or equal monthly instalments. This is “currency averaging” or rupee cost averaging. Another method is value averaging. This is more complex. In value averaging, the investor targets a growth in value by the same amount every month. This implies selling under some circumstances.
For example, say, the investor wants the portfolio value to grow by Rs 1,000 a month. In the first month, he buys Rs 1,000 worth of units, which are priced at Rs 10. Say, the unit value depreciates by 10 per cent. Then, in second month, he buys Rs 1,100 of units. The price rises by 10 per cent, and he buys Rs 800 in the third month. Then the price rises by 20 per cent. In the fourth month, he buys only Rs 400 worth of units. The price rises by another 20 percent and in the fifth month, he buys only Rs 200 worth. Then the price zooms by 30 per cent and in the sixth month, the value-average is holding a portfolio worth Rs 6,500. This time, he sells Rs 500 worth of units.
This stylised example shows how value averaging works. At the end of this six-month period, the value-average has invested net Rs 3,000 and holds 300 units valued at Rs 6,000. In contrast, a normal EMI SIP would invest Rs 6,000 and the EMI-holder would own 517 units worth Rs 9,685.
The IRR is higher for the value-average and value averaging also has some practical advantages. It enables the investor to target holding exactly Rs X at the end of a given period. So, it can be used to park money in a volatile asset like equity to settle a loan principal, or some other fixed expense.
This example is given for a rising market. But, one disadvantage for value-averaging is that it requires larger sums to be invested when prices are falling. See the investment in the second month, for example. Of course, this means the value-average also buys more units in bear markets
and thus, stands to gain even more when the market turns bullish. Most investors find value averaging a tedious process and stick to SIPs, or just buy in lump sums. In a sustained bull run like the current one, where price have risen over 40 per cent in 15 months, value averaging systems have edged close to “zero-buy” or to sell mode. This is the other advantage of value-averaging; it reduces equity exposure in a very bullish market.
Value-averaging systems can also be tied to “reverse STPs”, where equity profits are being booked and transferred to debt funds. If the Reserve Bank of India does cut rates that could be a good strategy.