What is Rupee Cost Averaging?
Rupee cost averaging is a strategy where you aim to reduce your average investment cost by investing regularly in the market. It follows the same principle as buy low and sell high, but slightly different. In rupee cost averaging, you invest more when the markets fall and less when the markets are high. You won’t be altering your investment amount, but the number of units you get when the price falls is higher than the units you get when the price increases. So basically, you buy more when the markets are cheap and less when markets are expensive. This will reduce the overall cost per unit, increasing the returns in the long term.
Let’s understand how rupee cost averaging works with a simple example.
Let’s say you allocate Rs 60 per week for lemons in your budget. If the price of lemons is Rs 5, you will get 12 lemons at Rs 60. Suppose the price falls to Rs 4 after one week. You can buy 15 lemons for the same price of Rs 60. But if the price increases to Rs 6, you can buy only ten lemons. But your average cost is Rs 5 per lemon, even though you didn’t buy all the lemons at Rs 5.
The same applies to investing as well.
If the security price is Rs 1000 today and you plan to invest Rs 5,000 every month, then you will get five units. Suppose the price drops to Rs 800 in the next month. You will get six units of the security. Alternatively, if the price increases to 1,200, you will get only four units. As the price falls, you are getting more units and vice versa. The average cost of investing in the security is Rs 1,000, which is lesser than your latest cost price, Rs 1,200.
We have explained in detail how rupee cost averaging works for mutual funds later in the article with the help of an example.
Characteristics of Rupee Cost Averaging
- Long-term strategy: This is a long-term strategy wherein you invest money regularly for a long term to reduce your average cost of investing.
- Investors don’t have to time the market: By investing consistently throughout the market’s ups and downs, you don’t have to worry about timing the market.
Advantages and Disadvantages of Rupee Cost Averaging
Following are the advantages of rupee cost averaging
- Low cost of investment: This helps lower the average cost of investment through regular investments.
- Avoids timing the market: It removes the pressure of timing the market and avoids investing at the wrong time. The strategy works best when markets are volatile.
- Inculcates financial discipline: By investing regularly, you can become financially disciplined, making you achieve all your financial goals.
- Accumulate wealth: With rupee cost averaging, you can accumulate more wealth, as the returns are higher due to low investment cost.
- Hedging tool: In a falling market, rupee cost averaging is very beneficial and can be used as a hedging tool.
- The best strategy for cyclical sectors: This works best for cyclical sectors and stocks.
Following are the disadvantages of rupee cost averaging
- Long-term strategy: It is a long-term investment strategy and doesn’t work for short-term goals.
- Limited applicability: The strategy only works for regular investments, not one-time or lumpsum investments.
- High transaction costs: Frequent buying can lead to higher transaction costs than a lumpsum investment.
- Doesn’t indicate when to sell: The strategy only gives a buy-side strategy. It doesn’t tell when to sell your investments.
- High losses: If a stock or mutual fund is in a downward trend due to its underperformance, rupee cost averaging will lead to huge losses.
How Does SIP Help in Rupee Cost Averaging?
When investing in mutual funds, you can either invest in lumpsum or at regular intervals through SIP (Systematic Investment Plan). In SIP, you invest a certain amount every month or quarter. By investing regularly, you are avoiding timing the market. The primary advantage of investing in mutual funds through SIP is rupee cost averaging.
In rupee cost averaging, you buy a greater number of units when the Net Asset Value (NAV) falls and a smaller number of units when the NAV increases. By investing throughout different market cycles, you are lowering your average cost of investment and spreading your costs over time.
Let’s understand this with the help of an example. Suppose two friends, Ram and Shyam, want to invest in mutual funds. Ram, having the capital, prefers to invest all at once, and Shyam chooses SIP for investment. If Ram invests Rs 1.8 lakhs at a NAV of Rs 20 and Shyam invests Rs 15,000 a quarter for three years at different NAVs, let’s see the returns for both.
|Quarter||NAV||Number of units|
|Year 1: Quarter 1||20||750|
|Year 1: Quarter 2||18||833.3|
|Year 1: Quarter 3||17||882.3|
|Year 1: Quarter 4||15||1000|
|Year 2: Quarter 1||13||1153.8|
|Year 2: Quarter 2||15||1000|
|Year 2: Quarter 3||18||833.3|
|Year 2: Quarter 4||20||750|
|Year 3: Quarter 1||21||714.3|
|Year 3: Quarter 2||23||652.2|
|Year 3: Quarter 3||25||600|
|Year 3: Quarter 4||24||625|
The number of units accumulated by Ram is 9,000 for Rs 20 per unit. However, Shyam acquired 9,794 units at an average cost of Rs 19.1 per unit. The gain for Ram is Rs 4 per unit, whereas for Shyam is Rs 4.9 per unit. For the same investment amount, Shyam has a higher number of units at a lower cost when compared to Ram. His gains are also higher by Rs 0.9 per unit. This shows that through rupee cost averaging you can reduce your investment cost and increase your returns in the long run.
By investing in mutual funds through SIP, you are automatically benefitting from rupee cost averaging. This eliminates the stress of timing the market and increases your return in the long run. But it is important to note that you must be consistent with your investments. Only consistency can help you accumulate wealth and reach your financial goals.
Frequently Asked Questions
SIP can be used in both bull and bear markets. However, in a falling market, you will be able to accumulate a greater number of units at a lower cost, which will reduce your overall cost of investment. A bull market followed by a bear market will lead to greater gains.
If you are investing in mutual funds through SIP, you will automatically benefit from rupee cost averaging. In other words, your average investment cost reduces over time, leading to greater gains in the long term.
Rupee cost averaging works best in volatile markets. By investing a certain sum throughout a market cycle, you can reduce your cost of investment. When the markets are going up, you will buy a smaller number of units and get a greater number of units when the markets fall.
When the prices of securities are moving upward, you will get fewer units for the same investments. In contrast, you can get more units for the same price when the price goes down.
The value cost averaging is similar to rupee cost averaging. But instead of investing a fixed sum every month, you will set a target amount for the portfolio and invest based on the gain or shortfall. Let’s understand this with an example. If you invest Rs 5,000 in a mutual fund in the first month. After a month the value falls to Rs 4,500, you will invest Rs 5,500 to maintain the portfolio value. But if the value increases to Rs 5,200, you will invest only Rs 4,800. It is slightly difficult to monitor your portfolio every month and adjust the investment amount accordingly. Hence value cost averaging is slightly more difficult to implement than rupee cost averaging.