Suresh has just about opened a demat account and wants to know more about how to invest in stock market. Fortunately for him, his friend Shivani is an expert on the subject, having been a regular investor for a long time. He meets her up so he can understand more about share market basics. He has often heard the phrase rupee cost averaging being thrown around but has never managed to learn more about.
“Shivani, as I told you the other day, I finally managed to open a trading and demat account. I wanted to pick your brains a bit on certain terminology. For instance, I keep seeing rupee cost averaging everywhere…” Suresh tells her.
“This is as good a time as any to understand the concept, Suresh. As you are aware of how to invest in stock market, you also by now know that the nature of the market is volatility. By using rupee cost averaging, RCA, for short, you ensure that you avoid the risk of timing the market. You can lower the average cost of a share by investing periodically over the long term rather than in a lump sum manner.”
“Where does it come into play, then?” Suresh asks. “Typically, RCA is a term you would come across while talking about mutual funds and systematic investment plans (SIP) where investments are made at regular intervals.” “In the context of the stock markets, it works something like this: you buy a share today for Rs 110. Its cost drops to Rs 100. You then buy one more share in the hope that there’s a bull market. So, you now own two shares, and the average price is Rs 105. So, if you were to sell these at Rs 180, you make a profit of Rs 75 per share.,” she explains.
So can you give me an example of how rupee cost averaging works as opposed to lump sum investments? That would help me understand the concept better, Suresh asks.
“Happy to oblige?” Shivani exclaims. “Ok, so imagine you have allocated an investment of Rs 8,000 in shares or mutual fund units. You can invest it in one shot or split it equally over four.”
“In month 1, when the unit price is Rs 20, you buy 100 units. In month 2, when the unit price is 18, you can buy 111.1 units for the same Rs 2,000. Likewise, in month 3, when the unit price is 17, you buy 117.6 units for an investment of Rs 2000. In month 4, when the unit price is Rs 19, you buy 105.3 units for Rs 2000. So, when you add up the four months, the number of units you own is 434 when you use the rupee cost averaging method,” she elaborates.
“On the other hand, if you were to make a lump sum investment of Rs 8000 at a unit price of Rs 20, you would get fewer units, ie, 400. Just check out one of the tables I will source for you, and you will get a better idea of rupee cost averaging over a six-month period,” she adds.
“This method makes sure that you end up buying more shares when prices are low and fewer shares when prices are high, thereby averaging it all out, right?” observes Suresh.
“Absolutely, Suresh,” Shivani says. “The thing to remember is that the price paid for one share doesn’t matter. What matters is the average price of the share at the end of your buy. Your returns depend on this average price,” she adds.
“Thanks, Shivani, for making one of the share market basics so clear for me to understand. So, what are the ideal scenarios in which rupee cost averaging works best?” he asks.
Ideal scenarios for RCA
“If you are a beginner or want to stay away from the risk of timing the markets, rupee cost averaging works just fine. Also, if you are looking at the long-term, the periodic investments in stocks you make rather than a lump sum amount help you gain stable returns,” Shivani points out.
“If you are someone who wants to inculcate discipline, this concept could be just what you were looking for, Suresh,” she says. “That does sound like me, he says,” chuckling.
“Got it,” he says aloud and continues, “so, if I don’t have big lump sum amounts to spare at the beginning of my investment journey, but am confident of investing tiny amounts regularly, rupee cost averaging may be the best option.”
Shivani continues, “Many experts say the RCA concept works ideally in bear markets as dropping prices makes sure the average cost comes down over a period of time. But it could work in a bull market too, when you can invest in tiny amounts when there are price dips from time to time, although not drastically.”
Don’t lose sight of the basics
“And just remember, Suresh. If a stock keeps falling, then chances are that the company is not doing well. In such a scenario, there are chances that the stock may not rise in a while, and lowering the average cost of a share may not be of any use,” she points out.
“Yeah, I understand. This means I would need to research the company and keep track of developments, right?” Suresh asks. “ Yes,” exclaims Shivani, adding, “just because you use RCA doesn’t mean you forget the other share market basics!”
“I now have a trading and demat account, and it’s time I started putting into practice one of the share market basics you have just explained to me. Thank you, Shivani, for taking me through the concept of rupee cost averaging and teaching me more on how to invest in stock market,” Suresh says. “Any time! There is no better time than the present time, so get going Suresh,” she says as they move on to other topics.