Rupee Cost Average – Why it’s essential while Investing?
An overview of the Rupee Cost Average Approach: One of the basic strategies to succeed in the stock markets is to buy more when the prices are low. However, this involves in-depth knowledge to judge shares that are underpriced and perfect purchase timing. Today we try and look for answers in Rupee Cost Average (RCA) to reduce our losses from overpriced securities and make success in the long run.
What is Rupee Cost Average (RCA)?
Basically, Rupee Cost Average is an investment technique of buying a fixed amount of a particular investment consistently on a regular schedule over a long period of time, regardless of price. The Rupee Cost Averaging approach results in the average cost of the investment being lower in comparison to a single lump sum transaction.
RCA Relation with SIP
SIP (Systematic Investment Plan) allows an individual to invest in a fund, a predetermined amount at regular intervals. If we look at the above explanation of RCA we realize that a SIP allows us to buy fixed amounts in a fund on a regular schedule regardless of the price of the unit in the fund. Hence SIP helps an investor apply the RCA method and reap its benefits provided he/she indulges in the SIP for a long period of time.
Example to Understand Rupee Cost Average in SIP
Say for example we have Rs 4000 and decide to invest in an Index fund that tracks with the Sensex. As of January 1st, you have 2 options i.e to either invest in a lump sum or to invest by means of a SIP.
— Scenario 1: You Invest in a lump sum on January 1, 2020
— Scenario 2: You decide to follow a SIP (with a decision to do so even after the amount is exhausted)
The difference we should note in the two scenarios above are :
In scenario one to make a profit the NAV per unit would have to rise above Rs 413.0602. In Scenario 2 if we are to observe the average cost on Investment would be lower.
Average cost = Amount Invested/ Units Received i.e. = 4000/11.0971 => Rs 360.45229.
Hence the breakeven is lower in the second case while investing through the SIP route.
— Units Received
If the units received are compared it becomes apparent the more units are received in Scenario 2. In RCA more securities are purchased when prices are low and fewer securities are bought when prices are high. This allows any losses that were made during a purchase made when the prices are high to be balanced off when the prices are reduced.
Also read: SIP or Lump sum – Which one is better?
RCA and Investor Psychology
Generally, when we find products available at reduced costs we make sure we take advantage of the situation even if it resorts to hoarding. When it comes to stocks of a company, however, it is noticed that investors react differently.
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Unfortunately, healthy companies with strong financials are also exposed to market falls. In such situations, investors panic and sell their shares invested in the company. Nonetheless, an investor with good financials observes the financials of the company, and if it looks good, he views the situation as an opportunity. He takes advantage of the situation and gains more shares.
However, it is observed that many market participants follow basic human instincts. They do this to protect their capital from further reduction. What RCA does is protect us from our own psychology. When we indulge in RCA through a SIP we keep investing regardless of the price. When the market falls and even when the market rises. Hence if followed we reap the benefits of RCA in the long term.
RCA after a market crash
The Dow Jones market as on 03/09/1929 closed at $383. The Great Depression followed and devastated the US economy. The US stock market then took over 25 years to reach levels it stood at before The Great Depression. On 23/11/1954 the Dow Jones closed at $385. This would mean an investor would gain only $2 ( per $385) over a period of 26 years if he invested in 1929.
However, if an investor invested using DCA( Dollar Cost Average in the US) $10000 every year, the $260,000 investments over 25 years would be worth $1.5 million as of 11/23/1954.
This is because by spreading the investments even to periods when the markets were low the investor would benefit by not only making up for the loss incurred when the markets were high but also make larger profits when the markets normalize.
The Rupee Cost Average investment strategy definitely safeguards an investor from market bubbles. Unlike other investment strategies, applying RCA doesn’t involve complex strategy and does not even require daily market tracking. This makes it easier for any individual to engage and take advantage of the market. RCA, however, does not shed light on the right time to sell.
In the current situation of ‘The Great Lockdown, we can notice that the Sensex has fallen from the all-time high of January. But if an investor understands RCA applies accordingly, he would be able to profit greater once the market normalizes.
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Aron, Bachelors in Commerce from Mangalore University, entered the world of Equity research to explore his interests in financial markets. Outside of work, you can catch him binging on a show, supporting RCB, and dreaming of visiting Kasol soon. He also believes that eating kid’s ice-cream is the best way to teach them taxes.