In addition to streamlining your regular investments, SIPs also help to reduce the average cost of holding a bit.This is because you are investing a fixed amount every month and as a result, you get more number of units when the market is down and less number of units when the market is up.
Value averaging investment plan (VIP) is another concept that helps you augment this averaging benefit.
VIP averages at the minute level and in volatile markets, it generates around 1.5% to 2% additional CAGR over a five-year time period. So, how does it work? VIP does better averaging by putting more money to work when the market is down and reduces investment when the market is up.
We can better understand how the two plans work by assuming a monthly investment of `10,000 in a VIP and an SIP. To keep it simple, we assume that the rate of return expected is 1% per month (CAGR of 12.68%). In the first month, the investor puts `10,000 in the VIP and SIP. Since the assumed rate of growth is 1% per month, the invested value should grow to `10,100 by the time the second instalment is due. However, this rarely happens and depending on the market situations, the actual value will be either higher or lower than the expected value. Now assume that instead of going up by 1% as expected, the NAV has tanked by 5%, so the current value becomes `9,500. While the SIP investor will continue with the `10,000 investment, the VIP investor will compensate for the deficit of `600 (`10,100 `9,500) and make an investment of `10,600 (see chart).
At a growth rate of 1% per month, the first two instalments should have grown to `20,301 by the time of third instalment.Now assume that the market has jumped 4% during the second month and the invested value has reached `20,904. Since the current value is higher than the targeted value, investment for the month will be reduced by `603 (ie `20,904 `20,301) and the VIP for the month will be `9,397. In VIP, this process is followed month after month till you reach the goal date.
In addition to generating better returns, the probability of reaching your goal is also more likely with VIP because here the review is more frequent. In case of SIPs, the portfolio review is carried out at 6 months or one year intervals. However, it happens automatically every month for VIPs.
Suitability:
While everyone can invest through SIPs due to its simplicity, VIPs are not for all investors. It is better for small investors who are starting out to continue with SIPs. Compared to SIPs, VIPs are also more difficult to administer. While all mutual funds allow automated SIPs, very few offer automated VIPs. This means you have to do it manually or rely on your investment adviser or distributor or online mutual fund transaction portals like RoboMF.
Suitability also depends on the level of investor knowledge. VIP suits investors who are more vigilant and also have some basic understanding of economic cycles. Else the monthly volatility can put off investors from investing altogether.
VIP is more suitable for investors with deep pockets, because of the erratic monthly investment amounts. Though the variation will be small in initial months, it can become really large in later stages. For instance, a sudden demand for a high amount (say `30,000) may be difficult for an investor who can afford only `10,000 per month to cough up. Fixing a monthly investment band (eg `5,000 to `15,000) is a partial solution, but still you need access to a lot of money. Even if you fix a reasonable band of `5,000 to `15,000, this `15,000 may be required continuously for a few months, so you need to have that much surplus in hand.
VIP works only for disciplined investors and can be disastrous for spend thrifts. This is because there will be periods that may suggest zero in vestment and if the investor is not disciplined, this additional surplus may end up as consumption. Some of this problem can be tackled by using a combination of equity and debt funds. In this case, you can keep the total monthly investment amount constant and manage the VIP into equity schemes by increasing or reducing your debt fund combination.Even if the VIP demands higher investment in some months, you can manage it by switching from debt funds.
However, here the investors needs to take care of the additional taxation issues that could arise.
Just like SIP, VIP also works better in volatile markets and will not work in one sided bull or bear markets. Your equity exposure may be much less in raging bull periods like it was between 2002 -2007 or you may invest much more in constant bear markets like 1994 to 1998. And compared to SIPs, you need to give a longer time periods for VIPs. VIP is meant for the very long term and to get results, you need to give at least 10 years
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