Value Averaging : Summary
Systematic Investment Plans(SIPs), Value Investment Plans (VIPs), Value Averaging Transfer Plan( VTP) , Dollar Averaging Concept, Value Averaging Concept, are ALL usually associated with answering a question – “ How to invest money over a long period of time to get adequate returns, given that it is impossible to time the market exactly ? “.
It has been quite some time since I had done any analysis at a portfolio level. Was occupied in doing something on the relative value arb stuff . So, my mind was a VERY RUSTY and was not in a PLUG and PLAY mode for portfolio analysis. The moment I started looking at the plans available in the market, the first thing that hit me was- “Where is the mention of Risk in these products “? Yes, risk is an abstract quantity which can be defined in more than one way, but shouldn’t that somehow figure in an investment plan ?. SIPs , VIPs, VTPs are all focused /designed based on returns and they have no mention of risk! . At a 10,000 ft , it looks like they can be summarized as a mix of contra-trend following + formula based investment strategy.
As these thoughts were bouncing in my head, I stumbled on to the classic book on Value Averaging by Michael Edleson. As a concept , Value averaging is very simple to understand. You expect your portfolio to grow by a certain amount every month/quarter/year etc and accordingly you buy and sell the portfolio. Why should this method work ? Does it always work ? Is a better way for investing LONG term ? Tried going over the book to get some pointers to the questions in my mind. The fact that risk was not associated with any of these plans was a great motivator to read this book. Has the author addressed in some corner of the book about the risk associated with the investments ? What’s the book about ?
Timing the market is difficult. Some are successful but most get burnt. This book talks about two investment techniques called, dollar cost averaging and value averaging, both being a formula based investment methods where emotions are taken out of the investing process. The book starts off with some thing very obvious. The returns variation goes down as your holding period increases. Empirical histograms are plotted for various holding periods for supporting the above argument . Basically all this means is that volatility goes down over a longer time frame and returns are much smoother.
The book then gives an overview of Dollar averaging. Dollar Averaging is explained as a technique where a fixed amount of investment is made at regular intervals, thus resulting in – “buy less when asset values are high and buy more when asset values are less” , type of investment process. Thus on an average the buy price is averaged out and an investor is not exposed to fluctuations in the market price. So, in a sense it can be termed as “Buy low, Buy less higher”. It does not say anything about the SELL aspect. However there is a drawback in this concept. If the asset values keep going up, you end up buying lesser units of the assets, and hence on an average you are less invested in the market over a longer period of time. This is one of the reasons for its underperformance with a constant share portfolio. Hence a growth-equalized variation of Dollar averaging would be better than plain simple dollar averaging.
The book then gives an overview of Value averaging. Value Averaging is somewhat different tack than Dollar averaging. It basically means that the investor should keep a constant growth of value each month. The biggest advantage as compared to the Dollar averaging is that it gives an opportunity to sell. When the portfolio posts gain and is higher than the planned portfolio value, investor can opt in to sell a specific amount of portfolio so as to stick to the old plan. However the plain vanilla value averaging is still a problem as the constant growth of value that is to be followed becomes insignificant as the accumulation period increases. After a few years it might so happen that the entire value comes from the original investment made at a discount and the investor ends up selling and goes in to a de-accumulation state. So, obviously be it Dollar averaging or Value averaging, it is extremely important to get the long term trend incorporated in the formula based investment. One of the ways could be to incorporate inflation adjusted growth Or incorporate some number above the inflation adjusted growth rate. Here is something important
A bad year is a bad year even with value averaging.The investment vehicle you choose is far more important to your results than the mechanical rules you follow to invest in it. To that end, it is best to use value averaging with very diversified investments, such as a broad-based mutual fund or, preferably, an index fund.
Be it Dollar averaging or Value averaging, incorporating long term trend is the KEY to get effective returns. The right set of diversified instruments is extremely important. Even though the author advices to use index fund, how does value averaging work with a set of index funds representing various asset classes ? That’s an interesting thing to work on.
The book then goes in detail in to Dollar averaging and the ways to tweak the concept so that the portfolio keeps pace with inflation, short term volatility , long term overall growth of the market etc. 70 pages in to the book, I kind of stumbled on to the thing I was looking for. Here is what the author has to say on the risk and suggests to invest in lower risk instruments.
The reason for the shift should be clear. Investing in the stock market is great for long term goals, but as you approach your goal-spending requirement (for example, as tuition comes due), you most likely do not want your entire college fund sitting in a risky mutual fund. A bad market result could cause you to suddenly come up very short of funds at the last minute. Over time, it makes sense to gradually shift more funds from risky to less risky investments, realizing that your expected return will go down as you do this.
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It is wise to gradually down-shift your risk level as the time of your investment goal approaches. Start
with conservative estimates of how well your investments will do, and take opportunities to shift to lower-return, lower-risk investments later in the plan if you are doing well and if it suits your purpose. You will then be at less risk of missing your final investment target._
Basically the author is hinting at a glide path based investment policy. This is something the target date funds use it in their investment methodology. So, obviously a SINGLE instrument + SIP option is not the BEST option for the investors. You have to have different asset classes with different risk structures as you reach your target maturity for the investment. So, the author clearly hints that there is a need for glide path+ formula based investing plan for the investor.
At any point between the start and the target maturity, there are multiple paths to reach an investment objective. In the case of SIP, one can tweak the constant amount invested or one can tweak the growth rate of the amount invested to correct for incorrect returns estimates that would have been used at the beginning of the investment plan.
Finally there is a chapter on the details of Value Averaging incorporating growth rates. In this chapter, I found some mention about the area which I was looking for.
The big problems occur with value averaging (or most other strategies) when you have a really bad market performance after you’ve already built up a sizable portfolio toward your goal. Investors approaching their final goal in December 1987 were certainly shocked and disappointed by the crash in October of 1987 and certainly would have missed their end-of-year December goal, which had been almost achieved.
In some sense, the risk of bad performance hurts more as you get closer to your investment goal, because there’s really no time to recoup losses. To this end, it may make sense to be a bit conservative in your initial expectations.
Shouldn’t one be holding less of risky assets and investing more in a defensive kind of portfolio as time progresses ?
The book then talks about simulating various value paths and getting the distribution of terminal portfolio values. Obviously the returns are assumed to be log normal and the terminal values are simulated. There is an entire chapter on comparing strategies as a result of simulation.
At this stage of reading the book, it is best to simulate stuff and get a feel of results than merely looking at the results given in the book. After all, we are just taking about a single asset simulation. Well, you can take a hypothetical asset, simulate the performance of an investment under various asset value realizations.
For example, let’s take an investment of 2000 Rs Monthly is made in to VIP scheme which is structured in such a way that it grows by 1% every month. For a simulated asset path, the following shows the value path and monthly outflow for a 60 month period. The first graph shown below is the Value path which is what the investor’s portfolio will mirror. The second graph is the cash flows that will result in a simulated asset value realization.
Even though investor thinks that his value is going up by 1% every month,here is the interesting part..
One can use all the fancy metrics like IRR, MIR, etc …But let me stick to the very basic return i.e return on total investment = Final Portfolio Value / Sum( Cash Flows)
If you sum up all the cash flows from the investor , in the above run, it is Rs. 1,70,042 and the portfolio’s final value is Rs.166, 972 . They are almost the same value. So, what has VIP done in the above hypothetical run ? Even though your portfolio value is growing by 1% each month, what’s the final return on all the cash flows ? Zilch!
Now obviously an inference from one simulation is naive.. But the point to note that VIP like any investment can result in flat or negative returns.
To make a better inference, let me simulate 100,000 runs and see what’s the returns on the total cash flows.
What can one infer from the above graphs ?
The minimum and maximum total returns is –25% to 40% ..Mean and std dev of returns are about 1% and 7% respectively… So, after 5 years your total returns could be any of the following numbers present in the above histogram. However the mean and sd of the returns paints a rather sad picture for this hypothetical security. So, obviously there needs additional elements to a VIP plan to give better risk adjusted returns!
It can be empricially checked that a VIP scheme is much better than the SIP schemes floating in the market. However if you look at the above monthly cashflow graph, there is every possibility that , if the market tanks towards the end of target maturity of the investor, the cash flows are going to be erratic and the returns could be flat or even negative. If there is a limit on the max investment, then obviously the value path projected at the beginning of the plan will no longer be achieved if the market tanks towards the end of maturity period.
What’s the basic problem with the VIPs for a longer term investment horizon ? Well, if an investor looks at VIP and wants to invest with a specific Target Maturity and Target Value in mind, there is a chance that the volatility towards the end of the investment horizon might be bad for the entire portfolio. What’s the alternative ? Shifting of money in to different asset classes is a MUST as one moves towards to the Target Maturity Period.
For shorter term investment horizons, VIPs are a classic way to invest. To obviate idiosyncratic risk, the instrument chosen for VIP could as well be an ETF or a broad market based index. BUT for Longer term investment horizon, there needs to be a blend of VIP and an asset allocation scheme with gradual change of asset allocation scheme as one moves towards the target maturity date.
How do you design such a scheme ?.. Well, I have no clue. But there must be a way to do it.
The book finally ends with a suggestion that Value averaging is risky if it is followed using a single stock. A well diversified index fund / ETF is the best kind of instrument to use value averaging on. It is as close as one can get to “ Buy Low Sell High” with out a crystal ball.
Takeaway
Well, Value averaging and the way it works is obviously any reader’s take away.
But for me, the takeaway is that, it is very much possible that a plain vanilla VIP might give flat or negative returns in the long run. Hence there is a need for a product where Value Investment Plans are combined with asset allocation strategies , that change as the investor moves towards the target maturity date.