VAP: a powerful tool
In contrast to RSPs, also known as dollar cost averaging (DCA), which rely on a fixed investment amount at each period, value averaging dynamically adjusts these amounts in response to markets. Investors may invest nothing in some months, a large amount or a small amount.
Value averaging works on the idea that as an investor you want to increase your portfolio by a certain value over time, for example, $1,500 each month. Some of this value you could contribute as an incremental investment each month, perhaps coming from your bank account using GIRO, but some of it you hope to come from the gains in your existing portfolio due to market increase. The concept is shown in Figure 1 below which illustrates an investor aiming to add $1,500 into his or her risky (red) portfolio each month.
In Period 2 the full $1,500 goes into the risky funds. But in Period 3, which saw share prices rise, the investor made market gains of $700 (yes it was a good month!) meaning the risky portfolio is already worth $2,200. That only leaves $800 to come from cash to meet the $1,500 target of added value for that month. VAP recognises this situation automatically. In contrast, when markets are less kind, say the risky portfolio lost $300, the investor would need to add $1,800 of fresh money to the risky portfolio to keep on track of adding $1,500 in value that month.
The net result is that when markets are trending up your cash is called on less. When markets decline, more cash flows in and your fresh investments increase. It's simply a twist on the idea of buying low. Research suggests that the method results in higher returns at a similar risk, especially for high market variability and long time horizons.
More detailed illustrative examples are shown below.
Extremely volatile markets: VAP versus traditional RSP
Value add target of $1,000. Illustrative only. Source: dollarDEX
In addition to the basic idea discussed above, value averaging incorporates another feature absent in dollar cost averaging - the target annual return of the portfolio. The investor provides this information when he or she starts the VAP. This extra information is used by the value averaging formula to ensure a pre-determined level of portfolio growth*. So as well as trying to add $1,000 each month the investor is trying to grow the portfolio at, say, a level of 5% per year. The VAP formula is smart enough to do both.
dollarDEX VAP also allows investors to set a maximum and minimum dollar amount for fresh money to invest per month. This is to avoid surprise withdrawals of very large amounts from your bank account, for example, when markets have corrected severely.
dollarDEX VAP also allows investors to choose a benchmark to determine the state of the market at the point of investment each month. This is used to calculate the amount of fresh money needed to satisfy the value added target. To avoid the problem of delayed unit trust prices (typically behind the market by 2-3 days) investors may use a proxy for the "missing" fund prices, such as the relative value of the STI. This helps to keep the VAP formula up-to-date on markets.
VAP is now available exclusively at dollarDEX,for cash, CPF and SRS investments. With cash and SRS investments you need to have at least two months of fresh investment as "seed money" (which would be $2,000 in the example above) in a cash management fund, and optionally to have a GIRO set up on the account you use for value averaging.
SummaryVAP is extremely useful for a gradual investment of lump sums (not only for regular savings), VAP helps you take advantage of market volatility by automatically investing more when markets are down, and less when markets are up; it takes away some of the psychological reluctance some investors have to invest when markets are down. You can set two main parameters to VAP:
- Amount of value to add each month, for example, $1,000.
- Growth rate of the portfolio, for example, 5% per year.
*Of course, if your target return is unrealistically high and markets are in the doldrums you probably won't meet your hoped-for return in the short-run, or you may find that your monthly GIRO deduction is very high in order to keep the portfolio growing at the high rate.