And don't ask me the impact of this additional 2-3%, compounded over time can be. Humongous, to say the least...Read on..
Systematic Investment Plans (SIPs) are the simplest and the most powerful tool to get into Mutual Funds. They force you to follow Wealth Management Principles like 'Pay Yourself First' and the 'Amazing Power of Compounding'.
Not only that, SIPs reduce your average cost of holding, thus reducing your market risk. 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.
You can get even more efficient with SIPs. Read the post here --> 5 Simple Strategies to make your SIPs work harder
What is VIP?
Value averaging investment plan (VIP) is another investment strategy that helps you augment this averaging benefit. VIP averages at the minute level and in volatile markets, it generates around 2% to 3% additional CAGR over a five-year time period.
VIP Working Principle
VIP does better averaging by putting more money to work when the market is down and reduces investment when the market is up, unlike SIP which invests a consistent amount irrespective of the market being up or down. In nutshell, SIP gives you 'simple' rupee cost averaging while VIP gives you 'weighted' rupee cost averaging.
VIP Functioning with Example
We will try and understand how the two investing strategies (VIP and SIP) differ. To do that, let us make some basic assumptions:
Monthly Investment : INR 10,000
Expected Returns (over long term) : 15% CAGR (1.25% monthly)
Month 1
SIP Investment : INR 10,000
VIP Investment : INR 10,000
SIP Expected Value after 1 Month : INR 10,125 (assuming 1.25% returns per month)
VIP Expected Value after 1 Month : INR 10,125 (assuming 1.25% returns per month)
However, this expected value is most unlikely to be met perfectly. 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 1.25% as expected, the NAV has tanked by 5%, so the current value after Month 1 becomes INR 9,500 in both cases. The difference in the two strategies (VIP vs SIP) starts after Month 1, i.e. when it comes to investing for Month 2
Month 2
SIP Investment : INR 10,000
While the SIP investor will continue with the INR 10,000 investment, the VIP investor will compensate for the deficit of INR 625 (INR 10,125 - INR 9,500) and make an investment of INR 10,625.
VIP Investment : INR 10,625
Month 3
SIP Investment : INR 10,000
While the SIP investor will continue with the INR 10,000 investment, the VIP investor will have to re-calculate the amount to be invested.
At a growth rate of 1.25% per month, the first two installments should have grown to INR 20,959 by the time of third installment. Now assume that the market has jumped 6% during the second month and the invested value has reached INR 21,332.
Since the current value (INR 21,332) is higher than the targeted value (INR 20,959), investment for the month will be reduced by INR 373 (ie INR 21,332 - INR 20,959) and the VIP for the month will be INR 9,627.
VIP Investment : INR 9,627
In VIP, this process is followed month after month till you reach the goal date.
Merits of VIP Investments
1) The prime benefit is the additional 2-3% returns generated by VIP investing strategy over SIP investing strategy. And this 2-3% over a long term (10+ years) is bound to have a massive impact on your corpus.
2) In addition to generating better returns, the probability of reaching your goal is also more likely with VIP because in this case, the portfolio review is more frequent. Usually, in case of SIPs, the portfolio review is carried out in almost one year intervals (and that too with disciplined investors). However, it happens automatically every month for VIPs. Therefore, a poorly performing fund is more easily detected and recovery action is more likely in this case.
Demerits of VIP Investments
1) While everyone can invest through SIPs due to its simplicity, VIPs are not for all investors. SIP is the recommended mode for small investors.
2) Compared to SIPs, VIPs are more difficult to administer. While all mutual funds allow automated SIPs, very few offer automated VIPs. This means you have to do the calculation manually or rely on your investment adviser or distributor or online mutual fund transaction portals.
3) 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.
4) 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 INR 30,000) may be difficult for an investor who can afford only INR 10,000 per month to cough up. Fixing a monthly investment band (e.g. INR 5,000 to INR 15,000) is a partial solution, since this INR 15,000 may be required continuously for a few months, so you need to have that much surplus in hand.
5) You need discipline to invest in VIPs. This is because there will be periods that may suggest zero investment and if the investor is not disciplined, this additional surplus may end up as consumption.
6) VIP works better in volatile markets and will not give any additional benefit over SIPs in one sided bull or bear markets. The more the volatility, the more the benefit of VIP over SIP.
Summary
VIP definitely has an edge in terms of returns. Go for it. However, VIP works only for disciplined investors and can be disastrous for spendthrifts. Only if you are near your goal of financial freedom, are financially savvy, have the time to monitor the investment amount every month, have liquidity in your investment portfolio to increase or decrease your monthly investment - then you should go for VIPs, else you may very well stick to the evergreen SIPs.
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The book "From the Rat Race to Financial Freedom" has many such investment concepts explained in a very simple and uncomplicated manner, especially in the Indian context.
Cheers
Manoj Arora
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Hi Manoj, Indeed it is a nice article, there are lot of similarities between you and me , You worked in an IT and I also have been working in IT and love writing on personal finance, here is an article about Mutual Funds vs Real Estate, I hope you would like it and do let me know your thoughts
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DeleteYour blog have good article for SIP investment which is so valuable for me and you have done good job on your blog which is good for your blog lover, thank you.....
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