Value averaging method ­— antidote for investing in a volatile market?

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  • Wednesday, 14 Sep 2011

RETAIL investors are jittery after the dizzying, volatile few weeks, which saw the wild 4-5% swings in the stock markets and the high volatility in the markets.

CNN Money quoted a veteran New York Stock Exchange trader with 43 years experience as saying: “It’s the craziest week I’ve ever seen. Ever.”

For those people who had invested in unit trust funds using the lump sum method, they may be experiencing emotional and physiological reactions somewhat similar to the experience during a roller coaster ride.

That leads us to the question that lingers in many unit trust investors’ mind: how to invest in a volatile market environment?

It may be true what unit trust sellers say that unit trust funds are diversified and thus have lower volatility, but we also see unit trust funds, especially the equity and aggressive equity funds which could lose as much as 52% in a single year in 2008.

One may claim that The Great Recession of 2008 is a one- off event, but the market is already comparing the recent sell- down with what had happened in 2008.

Thus it is time for unit trust investors to start asking if their lump sum unit trust investing method is a smart one, especially in a volatile market environment.

My argument is that we will see more volatility in the market in the future years.

I would like to introduce value averaging (VA), a simple mechanical investing method introduced by Harvard professor, Dr Michael Edleson.

Value averaging is a smarter mechanical investing method, compared to its cousin, Dollar Cost Averaging (DCA).

This is because VA will buy even more units when a unit trust fund price is declining, thus accumulating units at even lower average unit price.

The VA method is also smarter than DCA when the fund price is rising, by buying less high price units, thus keeping the average unit price as low as possible.

The profit can be realised when the fund price rises above the average unit price in VA and when it hits the profit target.

In the work my financial advisors and I are performing for our VA investor clients, through quarterly switching in their unit trust funds since June last year, they had realised their profit when it hit their targeted return recently.

It is also worth noting that VA has the amazing ability in reducing investment risk.

In Diagram 1, you can see that when the unit price in Quarter 4 drops from RM1 to 50 sen, the return of VA is only — 26.3%, where as if an investor has invested a lump sum when the unit price is RM1, the return would be a whopping negative 50%!

In Quarter 8, when the unit price recovers from 50 sen to RM1, the return of lump sum is 0%, meaning that the investor has just got back his principal capital.

A VA investor will have already earned a handsome return of 52.6%.

At the end of Quarter 12, the unit price drops back to RM1 from a height of RM1.20 and the return of lump sum is again 0%.

In comparison, the VA method has a positive return of respectable of 26.9%.

This example concurs with the conclusion reached by Professor Paul Marshall in his research paper published in Journal of Financial and Strategic Decisions, entitled: “A statistical comparison of value averaging versus dollar cost averaging and random investment techniques”.

The research paper concluded: “Results strongly suggest, believe it or not, that value averaging does actually provide a performance advantage over dollar-cost averaging and random investment techniques, without incurring additional risk.”

Diagram 2 shows the above observations in graphical form to help readers understand why VA should be a preferred mechanical investing method.

It’s about time unit trust investors reassesses their investment strategies in view of the volatile market now. Value averaging investors will sleep well at night.

■ Lee Khee Chuan is a graduate in political science, psychology and economics from National University of Singapore. He is also a Chartered Financial Consultant, Certified Financial Planner and a Fellow of Life Management Institute, United States. He can be contacted at 016-888 0138.

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