What is Rupee Cost Averaging and how does it work?
When we talk of a Systematic Investment Plan (SIP), one of its most talked-about benefits is the rupee cost averaging. It is an investment phenomenon of averaging the cost of investments, which happens when the investors make regular investments periodically.
If you have heard the discussions on stock markets, you must have heard about ‘cost averaging,’ which happens when the investors buy an additional quantity of stocks at lower prices. As such, the average cost of the total portfolio quantity gets averaged, and the investors may break even their investments at an early stage when the valuation of the investments increases. Similarly, the investors may want to buy additional quantity of stocks while the stock is rising to benefit from the stock rally.
While the average cost of the total portfolio quantity may have increased, the benefit of future price increase will now be available. However, this concept of averaging casts a cloud of uncertainty over the investment amount as the investment quantity may be the same, but the value continues to change.
However, such uncertainty gets eliminated in mutual fund investments. This is because the mutual fund units may also be allotted in decimal fractions. As such, the investors have the liberty to specify a fixed amount for investment every month and the number of units so allotted may vary. So, while the simple cost averaging keeps the quantity of the investments unit in whole numbers, the rupee cost averaging keeps the investment amount in whole numbers and generally fixed for the investment period.
So, now that you know ‘what is rupee cost averaging,’ let us also talk about the benefits of rupee cost averaging. The investment principles always guide about ‘buy low, sell high’ strategy, which in simple words, means making investments at lower prices and selling at higher prices.
Let us also understand the concept of rupee cost averaging with an illustrative example. Suppose you register a SIP of ₹ 10,000 per month in a mutual fund scheme. The first SIP instalment gets invested at NAV of Rs. 25 per unit. As such, 400 units are allotted against the investment. If the markets rally during the next month, the NAV of the fund may have risen to Rs. 40 per unit. So, you will now get 250 units allotted in your investment folio. As such, over two months, you have an investment of Rs. 20,000 with 650 units. As such, the average cost per unit comes to Rs. 30.77 per unit.
Similarly, if the next month, the markets are under sharp correction and the NAV of the mutual fund scheme falls to Rs. 20 per unit. As such, you get 500 units against the monthly SIP investment. Due to additional investment at lower NAV, the average cost would have now fallen to Rs. 26.09 per unit for 1,150 units. This is how the rupee cost averaging helps you, averaging the costs at lower prices when the markets are falling and higher valuation for the overall portfolio when the markets are rising.
This also illustrates how rupee cost averaging helps you to eliminate the impact of volatility in your portfolio, as you invest across the market ups and downs. While the market volatility may impact the emotions to defer investing and booking profits at a later stage, the benefit of rupee cost averaging through SIPs inspires more confidence in you to continue making more investments.
With all these benefits, rupee cost averaging makes it easier to inculcate financial discipline into your lives. As such, it not only helps you accumulate a healthy sum over a period but also equips you with a potential for higher gains for your portfolio when the markets rally.