An investor tends to buy most when market is at peak and the least when it’s at bottom due to fear of loss. So, while investing regularly through systematic investment plan (SIP), you tend to average your rupee cost on investments. Most investors generally follow this standardize technique of SIP to invest regularly into mutual funds. There is alternative method of investment into mutual funds known as value cost averaging (VCA) technique. In this article, we shall understand the working of VCA technique and how it’s better than SIP investment option in different market scenarios while investing in mutual funds.
Concept of Value Cost Averaging (VCA)
VCA is a technique in which you would invest at regular intervals for a pre-defined period in particular mutual fund scheme. Your periodic investment contributions in this scheme would vary due to volatility in the market. This technique ensures that your portfolio value rises by a specified amount at each installment regardless of market movements. It helps to achieve your financial target value in a more stable way.
How does VCA technique work?
In VCA technique, you (as investor) need to focus on your target value of your portfolio to go up by fixed amount each month. You are required to set a predetermined worth of the portfolio in future time period considering your investment tenure. Then you may buy or sell mutual fund units of the investment such that the pre-determined portfolio worth is achieved at each revaluation point.
So, when market is bearish (declining), you are required to purchase relatively more units to maintain your portfolio value. Similarly, when market is bullish (rising) you are required to purchase relatively few units or might even redeem some units to maintain portfolio value at the desired level in particular month.
Illustration of difference between value cost averaging (VCA) and rupee cost averaging (RCA)
Assume, Mr. Zainul Bhaigora (an investor) wants to grow his portfolio by Rs 10,000 every month from April, 2012 to March, 2013.
Analysis of above illustration
Mr. Zainul Bhaigora will be investing Rs 10,000 in the first month (Apr-2012) and then make subsequent contributions based on the total portfolio value. As we can observe, his market value of portfolio dropped in May-2012 to Rs 9000 (1000 units * Rs 9 NAV). So, he will invest Rs 11,000 in May month to maintain target value of Rs 20,000 for that month. Similarly, in month of December 2012, he would invest only Rs 2,000 to maintain his market value of Rs 90,000 in that month. Even, he would redeem profits from investment on regular basis if market value of holding exceeds target market value.
VCA allows investors to follow the prudent investment habit of buying more at lower prices and less at higher prices. Observe, in the month of July 2012 when the market rise investors following VCA technique purchased 606.06 units versus 833.33 units bought by RCA technique. In the following month, i.e. August 2012 when the NAV dropped, investors using VCA bought 1666.67 units as against 1000 units by those using RCA. Overall net average cost is lower at Rs 9.29 for VCA strategy versus Rs 10.49 for RCA.
Illustrations of VCA Vs RCA in different scenarios
Scenario 1: Rising market
When market is rising during bullish trend, you will be investing fewer amounts on periodic basis to reach your target market value. Also, the net average cost would be lower for VCA compare to RCA as illustrated in above table.
Scenario 2: Falling market
When market is falling during bearish trend, you will be investing higher amounts on periodic basis to get an advantage of lower cost and to reach your target market value. However, net average cost would remain lower for VCA vis-à-vis RCA as illustrated in above table.
Scenario 3: Sideway market
There are months when market moves in sideways. In such period, your investment amount would vary on periodic basis to reach your target market value. Net average cost would continue to remain low in this situation as compare to RCA.
Summary of difference between VCA and RCA
To gain an advantage of lower cost of acquisition per units for investors, HDFC AMC have introduced swing systematic transfer plan (STP) in the month of February, 2012. Swing STP works on the principle of VCA and plans to buy more when NAVs are low and buys less when NAVs are high to arrive at the target market value set by an investor. It redeems units or transfers the units to debt scheme automatically, once the portfolio value exceeds set targets. So, you enroll yourself in such facilities available with AMCs to reduce the average cost per unit and develop prudent investment habits to achieve your set goals.
Hiral Thanawala is a PGDM (Finance) graduate and Certified Financial Planner. He can be reached at firstname.lastname@example.org