It is rightly said! No One Can Time The Market; the biggest challenge of any investor is “what is the good time to buy, what is the good time to sell and vice-versa”. Therefore it is very difficult to measure the good or bad time for any investment. We never know whether market will go up or down in future, but there is one mechanism which helps in getting decent return (in case of losses, it can be minimised) in any volatile market and helps in reducing the risk from ups and down of market which is known as Rupee Cost Averaging (RCA).
It is the technique of buying a fixed dollar amount of a particular investment on a regular schedule, regardless of the share price. More shares are purchased when prices are low, and fewer shares are bought when prices are high.
Eventually, the average cost per share of the security will become smaller and smaller. Dollar-cost averaging lessens the risk of investing a large amount in a single investment at the wrong time.
For example, you decide to purchase $100 worth of XYZ each month for three months. In January, XYZ is worth $33, so you buy three shares. In February, XYZ is worth $25, so you buy four additional shares. Finally, in March, XYZ is worth $20, so you buy five shares. In total, you purchased 12 shares for an average price of approximately $25 each.
In the India, it is known as “Rupee-Cost Averaging (RCA)”
To understand Rupee Cost Averaging (RCA), its better we can take two scenarios;
- One investor had been investing Rs. 2,000 per month for one year in one mutual fund scheme in Systematic Investment Plan (SIP).
- At the same time another investor who invested Rs. 24,000 lump sum in the same scheme for one year of horizon .
Just look at the below table explaining both the cases as per there pattern of investments.
Now if you can see that the person who had invested lump sum Rs. 24,000 at the beginning with a buying price (NAV) of Rs. 200 and the number of units he bought was 120, but due to fall in market Rs. 24,000 of investment have gone down to Rs. 23,760, it means the investment loss is straight 1.00% on the principal.
On the other side the investor who invested on monthly basis in the same scheme and due to volatility within the NAV he was able to average out his cost of investments by investing a fixed amount every month which fetches him more number of units in falling market. Thus at the end of the tenure he made a profit of Rs. 1,667 [Rs. 25,667 – Rs. 24,000] i.e. straight 6.94% on the principal.
Now after observing both the scenarios you can very well make out, the investor who was investing every month rather investing lump sum in a volatile market made money because he was averaging out his cost by buying at highs and lows therefore he was able to maintain returns in positive side. Since it is a average price so it will always be higher than the lowest value and lower than the highest value.
Thus RCA is a simple way to smooth out the ups and downs of financial markets is to make smaller regular investments rather than one large lump sum.
Also remember; every investment has its own benefits and limitations. RCA may not work as expected in a growing market as the units/shares purchased at any time will be higher than the previous purchase, thus final value will not be that attractive which could have been expected from the lump sum investments.
Hope this article would help you to understand the effect of regular, disciplined investment and of course LONG TERM investments.
Do share your views.