This next strategy, called Value Cost Averaging, is an attempt to use the same theory as my previous strategy, Price Cost Averaging, but with better returns. Remember, in my last post we learned about the simplest investment strategy we teach, Price Cost Averaging (PCA). This is where you invest the same amount of money every single month, something that can be automated by setting up a direct debit with your broker. Some brokers, like Hargreaves Lansdown for example recently charged just £1.50 per trade when using this strategy every month.
The challenge with Price Cost Averaging is that you are unlikely to get more than 5% returns a year, unless you use this strategy with a very volatile stock, but this increases the risk. Now 5% a year for a younger person who has the next 40-60 years of investing ahead of them is fine but most readers will probably want more percentage returns.
How about 7 – 15% a year? This can be achieved using the next strategy, Value Cost Averaging (VCA) and is every bit as simple as Price Cost Averaging. Using the same concept of buying into an investment such as Gold, Silver and Oil every month, it attempts to lower the average cost over time by purchasing a little more in the months when the price is down and a little less when the monthly price is up.
So how does it work exactly?
Let us take the example below:
As you can see the price of the underlying instrument goes up and down. So where do we enter? Remember that with Price Cost Averaging, we bought £100 worth of shares every month, no matter what the price? With Value Cost Averaging, we do it differently. We are going to spend more when the price is lower and less when the price is higher.
So let’s start again with £100 a month as our base*. We are looking to buy less in the month where the price has gone up and more if the price has gone down. For example we are going to buy £75 worth of shares (less) on the months that are ‘up’, and in the months it is lower we put in £125 (more).
Over the two months you have still put in £200 and an average of £100 a month as if you had used the Price Cost Averaging strategy. So what does this mean for the end of the year i.e. what do you think happens to your average price compared to Price Cost Averaging? Do you think the average price using Value Cost Averaging is higher or lower than Price Cost Averaging.
The answer is that your average price comes down substantially because you are putting more money in when the price is lower, thereby pulling the average price down. Hence the name VALUE cost averaging because you are buying more at a better value.
This strategy takes just 10 minutes more a month than Price Cost Averaging but could deliver twice the amount of returns. With Value Cost Averaging we are aiming to outperform the market and aiming for anything up to 15% a year. And you can wrap it up in your Individual Savings Account (ISA) so it is 100% tax free. You can also do this within your Self Invested Pension (SIPP), so it is tax free for a number of years. Not paying tax on your profits MASSIVELY boosts your profits over time.
Further Improvements on Value Cost Averaging
There are several ways we can further improve on the Value Cost Averaging strategy. For example, we could invest even more if the price continues to drop, and even less if the price continues to rise:
If the price drops in successive months, then in the first month it drops ie August, you could invest £75, and in month 2, when it drops again, you could invest £100 in September and £125 in October etc. Equally, as you can see in the example above, if it rose, you can invest less, say £75 and if it rises again in the following month, you can invest less again, say £50. It really depends on your brokerage costs.
Please note that these numbers serve as examples only because clearly the brokerage costs would not make it viable to invest under £150.
A Word of Warning
When you looked at the falling price, I wonder if you had the idea of just putting double the amount of money into the trade to get the average price massively lower. For example, you start with £100 and then as the price falls next month, put in £200. More often than not, even the slightest upturn would mean profit. If it falls the next month again, just put in £400. This brings down the average price dramatically, meaning just a small up-tick will bring you back into profit.
A word of advice – do not do this …. ever. This strategy is called the Martingale strategy and works 99% of the time. “What’s the problem with that?” you might be asking yourself. “It sounds amazing, especially if it works 99% of the time”. The 99% does sound good – it is just that at some stage – it could be next month next year, in 2 years- the 1% will happen when it continues to fall until you have spent all your money and you have no more money to invest. Next month £800, next month £1,600, next month £3,200, next month £6,400 etc.
So how much more can you put in? There is no rule but we would add an extra 25% each time ie £100 then next month £125, then next month £156 etc.
Value Cost Averaging Summary
The idea is to invest more when the price falls and less when the price rises so that your AVERAGE price is at a lower VALUE, hence the name, Value Cost Averaging. This way, when the price rises, you will expect a handsome profit, much more than with Price Cost Averaging.
Remember that this strategy cannot be fully automated like Price Cost Averaging because we have to actively look to see if the price has risen or has fallen. However, it takes just 10 minutes a month and over time Value Cost Averaging makes you better returns for just a tiny bit more effort. I hope you can see this and start implementing it as soon as possible.
Why not give it a go. Simply use a free charting software package like Free Stock Charts, go back 2-3 years and see what would have happened with this strategy. Feel free to email me at firstname.lastname@example.org if you have any comments.
The next level can make you even better returns on your money, in not a lot more time. We will be exploring this in my next post.
In the meantime if you want to fast track your learning, then find out more about about my investing strategies by downloading my free eBook, The Lunchtime Trader.
To your success,