The intriguing and held-in-awe-investor Warren Buffet once defined risk as ?not knowing what you are doing.? Interesting and penetrating elements in this statement are its timelessness and applicability. And what makes it more pertinent is the right strategy with wise arrangements and adaptations. With the markets still to put up a clear movement with more troughs than crests, a strategy that would lessen your costs of buying into an investment option need to be a prudent one and in a way shield against abrupt risks. The strategy is called rupee-cost averaging (RCA). RCA in simple terms means investing a fixed amount of money each month into an investment such as a stock, or mutual fund or other investments. In this analysis, we would give you the applicability of RCA both in equity and mutual funds domain.
The equity perspective
In RCA, a fixed number of a share is bought regardless of its price. And more shares are bought when prices are low, and fewer shares are bought when prices are high. Eventually, the average cost per share will become smaller and smaller. For example, your fixed investment might buy 10 shares when the price is low and only five shares when the price is higher. RCA therefore lessens the risk of investing a large amount in a single investment at the wrong time (i.e. at an inflated price), and in a falling market, the average cost per share becomes smaller and smaller. This lessening average cost per share will help you gain better overall profits as the market increases over the long term. If the market is lower this month, you may lose money on the shares you bought last month, but this month you receive more shares, which, in the future, will help offset any losses. With RCA, you are able to take advantage of any low during these five months, guaranteeing you to invest at the very bottom because when it comes, you are simply doing what you do every month.
Once the market turns around, which it is likely to do in the long term, you?ll be ahead. RCA is also ideal for the investor who doesn?t have that big lump sum at the start but can invest small amounts on a regular basis.
The mutual funds? perspective
The expense ratio that mutual fund investors pay to invest in a fund is a fixed percentage of your contribution. That percentage takes the same relative bite out of a Rs 25 investment or regular installment amount as it would out of a Rs 250 or Rs 2,500 lump-sum investment. Compared to stock trades, for example, where a flat commission is charged on each transaction, the value of the fixed-percentage expense ratio is startlingly clear. Consider the following: a) By making a Rs 25 installment in a mutual fund that charges a 20 basis-point expense ratio, you pay Rs 0.05, which amounts to a 0.2% fee. By making a Rs 250 lump-sum investment in the same fund, you pay Rs 0.50, or a 0.2% fee. b) By making a Rs 25 investment in a typical stock through a broker who charges a Rs 10 commission per trade, you pay Rs 10, which amounts to a 40% fee. By making a Rs 250 investment in a typical stock through a broker who charges a Rs 10 commission per trade, you pay Rs 10.00, which amounts to a 4% fee.
These examples show that you have to buy more stock in order for the percentage of the commissions to go down. In comparison, the structure of the mutual fund expense ratio makes the investment more accessible: the no-commission trading of the mutual fund, coupled with low minimum investment requirements allows almost everyone to afford mutual funds. Of course, rupee-cost averaging with mutual funds isn?t a strategy that is limited to use by the less than affluent.
If you have a large sum of money and invest it all at once, you face the risk that declining financial markets will take a huge chunk out of your portfolio. Rupee-cost averaging offers the perfect solution to your dilemma. To facilitate a long-term strategy for investing large sums of money, many mutual funds offer investors the ability to make a lump-sum investment in a money market fund, from which predetermined amounts are automatically invested into a designated higher-risk mutual fund at pre-arranged intervals.
Regardless of the amount of money that you have to invest, rupee-cost averaging is a long-term strategy. While the financial markets are in a constant state of flux, they tend to move in the same general direction over fairly long periods of time. Bear markets and bull markets can last for months, if not years. Because of these trends, rupee-cost averaging is generally not a particularly valuable short-term strategy.
