Managing money is simple and straight forward once you understand the three basic principles of how money works. One is Pay Yourself First. Second is Compounding and the third is Cost Averaging. Let’s try to understand this concept of Rupee Cost Averaging.
Why Rupee Cost Averaging?
First of all, let’s find out why we need to bother learning about this concept. How does it help us, is the question.
When we consider investing, the big thing we get confused about is the market going up and down. Cost averaging essentially tells us not to worry about market fluctuations and not ever try to time your market entry or exit.
Let’s dig in to understand the concept. Let’s take an example.
Kumar wants to invest in mutual fund schemes or the stock market, but is worried that the market will fall after he invests as the market has run up too much too fast. But at the same time he is worried that the market may continue to rise and he might miss the rally and the potential gains that he would make with it.
Kumar is in a dilemma whether he should jump into the market immediately at the current level or continue waiting for the correction which refuses to come.
In short, Kumar is trying to time the market which lots of common investors do. Many a times common investors get it wrong when they try to time their market entry and have burnt their fingers due to the market fall post their investment. Or many a times many investors have been left on the sidelines watching the markets go up, waiting for the correction endlessly which never comes through when required.
Concept of Rupee Cost Averaging
If Kumar knew about Rupee Cost Averaging, he would not have worried. It is impossible for a common man to predict the movement of the markets. Hence it is best to start investing on a staggered basis by making regular monthly investments. This helps the investor to spread out his investments evenly over a period of time. This process of making regular monthly investments over a period of time at various market levels is known as Rupee Cost Averaging.
Let’s understand with the help of an example:
Kumar decides to invest Rs 100 every month in a SIP for 12 months. When Kumar starts the investment the NAV is Rs 10 and he gets 10 units. During the course of the year the NAV keeps moving up and down. So Kumar get units as per the movement in the NAV price.
We can see that Kumar invests Rs 1200 in the entire year and he gets 114.88 units for it. Kumar’s average cost per unit is Rs 10.44 whereas the actual average NAV is Rs 10.60.
It is not always possible for an investor to buy at the lowest point and sell at the highest point. Rupee cost averaging helps the investor to reduce this risk of timing the market to a great extent.
Benefits of Rupee Cost Averaging
From the above discussion, the benefits of rupee cost averaging can be summarized as follows:
- Inculcates the habit of regular disciplined investing
- Helps to ride out market volatility
- Protects the investor from incurring huge losses when the market falls drastically by averaging the purchase price at lower levels.
- Rupee cost averaging works at the time of buying securities as well as at the time of selling the securities.
- It frees the investor from the tension of trying to time the market or predicting the direction of the market and hence the problem of buying low and selling high.
- It helps the investor to buy more units when the market is down and buy fewer units when the market is high.
Rupee Cost Averaging helps the investor to buy more units of the mutual fund when the NAV is low and buy less units of the mutual fund when the NAV is high. But eventually the price gets averaged out over the long term. Thus rupee cost averaging helps in lowering the average acquisition price of the units but for this to happen the investor has to be disciplined enough to invest on a regular basis.
Applications of Rupee Cost Averaging
One popular method of using cost averaging is SIP. SIP is Systematic Invesment Plan where you give a mandate to your Bank to send a fixed amount to a mutual fund scheme.
Every month Rs X is transferred from your bank account to the fund scheme account. By doing this, every month on a stipulated date, you have created a system for your investments.
So when the markets are down, you get more units in your mutual fund scheme!
The biggest adavatage is that the SIPs help manage your emotions too. Because emotional decisions are not rational ones and they can hurt your investments. Since you have already created a system, there’s no decision to be made even when the markets are choppy!