Cost averaging vs value averaging

KUALA LUMPUR: It can be difficult to invest in a volatile market, as fluctuating prices make it very hard to make investment decisions. At the same time, you still need to stay invested to grow your money and achieve your financial objectives.

“It is important to recognise that the market is and will be volatile,” says Gary Gan, general manager, business development and marketing at Pacific Mutual Fund Bhd. “The key is to implement a carefully designed investment strategy that can help you deal with volatility.”

While the best course of action would be to try and anticipate the market movements and move your investments accordingly, it is a difficult endeavour, as even the experts can attest. Universally, ringgit cost averaging has been the popular investment strategy for investors. “

It is a strategy where you invest equal amounts of money regularly regardless of market prices or conditions,” says Tony Khong, founder of Signalpoint Sdn Bhd. Ultimately, the goal of cost averaging is to even out one’s investment value over the market’s peaks and troughs.

The cost averaging method results in more units being purchased when prices are falling while fewer units are purchased when prices are rising, all for the same amount of money. “To provide greater returns using a similar method, value averaging is introduced,” says Gan. “Generally, value averaging is an approach where you contribute more [than your fixed amount] to your portfolio when the market is down, and a smaller amount when the market is up.

The goal is to accumulate more units during a down market and fewer units when the market is moving upwards.”
We weigh the costs and benefits of applying the value averaging strategy over the cost averaging strategy in a unit trust portfolio.

What is value averaging?

The concept originated from former Harvard University professor Michael E Edleson in 1988. The term is more widely used in the stock-investing world.

The investor sets a predetermined worth of the portfolio in each future time period, as a function of the size of the initial investment, the size of periodic investment and the yield expected. “The investor then buys or sells sufficient ‘shares’ or units of the investments such that the predetermined portfolio worth is achieved at each revaluation point,” describes Edleson in his book Value Averaging: The Safe and Easy Strategy for Higher Investment Returns.

Value averaging is a more challenging method, as it requires calculations at different points of time, says Khong. “You need to review the difference between the actual and desired values of your portfolio at fixed time intervals.”

Based on the original definition by Edleson, the actual performance of your unit trust investment after a given time frame — for example, monthly or quarterly — will determine how much you need to invest to achieve a predetermined value of your investment.

For instance, in the previous quarter, you have invested RM1,000 in Fund A and you have set the value of the investment in the current quarter to be RM2,000; but due to a fall in the unit price in the current quarter, your portfolio value before you make the new investment is RM900. This implies that you would need to top up an investment amount of RM1,100 (RM 2,000 ­­‑ RM 900) in this quarter.

The theory of value averaging involves investors adding a larger investment amount as the value of your investment falls. “It assumes that you have deep pockets. But, you could potentially run out of investment money,” says Khong.

On the flip side, the value averaging exercise also “forces” you to take profit. Gan says that this happens when the actual value of your portfolio is higher than the desired value. “You then sell off or switch your investment to a cash fund to bring the value back to your desired level. You will be looking at your portfolio value when applying the value averaging method; instead of headlines or news.”

An analysis by Personal Money (see Table 1) shows that regardless of the market condition — rising, falling or fluctuating — the average cost of investment for value averaging is always lower than cost averaging (with the assumption that the value averaging investor predetermines his desired investment value at each period).

To give an apple-to-apple comparison, the internal rate of return (IRR) is used to do a comparison since both methods involve cash inflows and outflows at different periods. This method mimics the study done by Paul S Marshall, an associate professor of Management at Widener University in Chester, US, in his 2000 research titled “A statistical comparison of value averaging vs dollar cost averaging and random investment technique”.

IRR is the rate of growth expected by taking into consideration all the cash inflows and outflows at different points of time. Thus, the length of the investment time horizon, the [ringgit] amount invested and the market price of the investment in each period are required to calculate each technique’s cash flow pattern. It is shown from our study that the internal rate of return for the portfolios using the value averaging method is always higher than the portfolios that use cost averaging.

While it is shown that value averaging does generally lower the average cost and gives a higher IRR, do note the time required, as you need to be actively involved. “Consider the amount that you are setting aside at each interval. Too-small amounts can lead to an immaterial absolute difference. It can then be too cumbersome to do value averaging,” says Khong.

So, ask yourself if it is worth the effort. Gan adds that you need discipline in applying the value averaging method since you need to take action on your investment portfolio. “This is also where emotions take place compared to an automated cost averaging plan. If you react to headlines frequently, then value averaging may not be for you.” He suggests that investors should give a meaningful time frame of five years for both methods.

Variations of value averaging

Locally, the value averaging technique has been modified based on investors’ needs. “There is no one-size-fits-all [method],” says Gan. “Since each individual has his own parameters, such as the amount that he can afford and his risk appetite and time frame, value averaging can come in different ways. It can range from no fixed investment date to one based on how much the unit price has fallen.”

For instance, if the current unit price has fallen by 5% compared with the unit price of your first investment, your investment amount is increased by 5% from the first investment amount. This means that if your unit price falls by 5%, it prompts you to increase your investment to RM1,050 (assuming your initial investment is RM1,000).

Nevertheless, you can end up worse off being a value averaging investor if the pre-set parameters are too stringent for your portfolio. Gan illustrates a difference between cost averaging and value averaging plans using a local equity fund.

“Let’s say the value averaging plan works on the assumption that a top-up of RM100 will be made in any calendar month only if the portfolio value has fallen by 5%. Further to that, after the top-up, the new portfolio value will be taken into account for the next trigger instead of the initial amount.”

He found that a monthly cost averaging plan of RM100 from Dec 31, 2004 to Dec 31, 2009 yields an overall return of 39.38% on the RM6,100 cumulative investment amount while the value averaging plan that has an initial investment of RM100 on Dec 31, 2004 gives a 68.14% return on Dec 31, 2009. “Using the above variables, for the value averaging approach, there were only two top-ups (October 2008 and March 2009) after the initial investment. Hence, the five-year return of 68.14% was for a RM300 investment only.”

Khong opines that there can be flaws to value averaging based on the price of unit trust investments. “What if there was an income distribution leading to a fall in the unit pricing? Then, do you ‘value average’ due to the fall in price that was not caused by the market condition? Unless you know how to make an adjustment for this, you will probably get the calculation wrong.”

Thanks www.theedgemalaysia.com

Source:http://www.theedgemalaysia.com/personal-finance/182697-cost-averaging-vs-value-averaging.html.