Rupee Cost Averaging is a technique to limit your losses. It is an investment technique which enables the investor to make more money from his/her investment by limiting losses. By using this technique, the investor can avoid one of the biggest mistakes of new investors. By investing in a small amount of money at the beginning of the year and then slowly increasing the investment amount after a few months, the investor is able to minimize risk and make money without over-investing.
Rupee Cost Averaging is a system where you purchase a lot of rupee per month and purchase as many stocks as possible in that month and then sell the stocks at the end of the month. Okay, this is a little different. Rupee Cost Averaging is a system where you purchase a lot of rupee per month, and then invest in stocks to generate returns. The idea behind this is that you pay a slightly higher price each month of investment, but the end result is a much higher return than if you had bought stocks straight from the market.
Just as long term investing is an investment strategy, rupee staggering is an investment strategy that allows you to invest money with less risk. This may cause people to stop timing the market.
In rupee averaging, the investor does not use all his resources to buy an asset at a particular time. Instead, the funds are spent in small amounts to acquire the asset over a specified period of time (for example, the next two years). This is called the distribution of money.
Why distribute? Because our markets are volatile. Sometimes the prices are high and sometimes the prices are low. According to the rules, you should buy investments when they are undervalued. Overvalued assets should also be avoided.
But what if an investor doesn’t know which price is overvalued and which is undervalued? This happens to most people more often than not. Because people are not trained to value assets, they end up buying them at the wrong price.
This is a risk where the average person invests their money and ends up taking a loss. What’s the solution? You can eliminate the risk of loss through the following two strategies: (a) holding for the long term and (2) spreading the value in rupees.
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Roepie Middelings Concept
Suppose a farmer has bought new land to farm. One of his relatives said that not all land is equally fertile. How will the farmer deal with this risk?
Since the farmer could not know which plots were less fertile than others, he chose the strategy of spreading all his seed evenly over the field. In this way, the 16 seeds are not all concentrated in one plot, which minimises the risks.
How did the farmer do? The farmer divided the whole plot into sixteen equal plots. He planned that each segment would be sown with a single seed. If several segments are less fertile, only the seeds sown in the less fertile segments are at risk. The seeds of balance will grow well.
The same analogy can be applied to understand the notion of rupee averaging. Let’s see how…
Analogy
- Seeds: Each seed sown in 16 segments represents a micro-investment. You can think of it as our SIP (say Rs 2500 per month) which we make every month to buy mutual funds (assets).
- Segment (grey) : Shaded segments represent months when mutual fund stocks are overvalued (high NAV). These segments were numbered 1, 3, 6, 9, 12 and 15. With a SIP invested during these months, you can buy fewer units. As a result, they will have lower capital gains in the future.
- Segment (white) : The white segments are months in which a mutual fund’s NAV is undervalued. You can buy more shares with the SIP invested during these months. As a result, they will realize added value in the future.
Comment: Some months bring less capital gains and other months bring high capital gains. Therefore, the future total return is averaged. We will learn more about this when we look at concrete examples].
From an investor’s point of view, it is more profitable to buy shares in months 2, 4, 5, 7, 8, etc. (blank). (blank). (blank). The investor should avoid months like 1, 3, 6, 9, etc. (gray color). (gray color).
But since one cannot know which months will be undervalued and which will be overvalued, one has opted for systematic investing. But even in the event of a decline, the returns are average.
What does rupee averaging mean?
This is an investment strategy where money is invested gradually in equal instalments, rather than all at once.
To understand the calculation of the average in rupees, let us take an example. Suppose you have Rs 20,000 to invest. The stock market is going down and you want to invest your money (see chart above).
You can follow two strategies to invest your money:
- Invest in one time: Invest Rs 20,000 at a time (in January). You buy units in mutual funds with a NAV of Rs 100 in January. This gives you 200 numeric units (20,000/100). Suppose the NAV at the end of August is still Rs. 100 million. Therefore, your profit in August will be 0%.
- Invest systematically: They divided Rs 20,000 into 8 equal payments of Rs 25,000 each. Then invest Rs 2500 every month from January to August (for 8 months). The NAV of the mutual fund changes every month. The total number of units collected from January to August is therefore 214.28 units (see chart for calculation). So your profit until August is 7.14% (see calculation above).
You will see that the same mutual fund has different returns for the same time horizon (0% versus 7.14%). How did this become possible? Simply by following the right investment strategy. What is the right strategy? Systematic investments that lead to an increase in the value of the rupee.
But the average in rupees also has its limitations. Read on and find out more. Remember: When I saw the limits, I kept my SIPs to a minimum. So read to the end to find out the secret].
When does rupee averaging work and when does it not?
In general, rupee averaging works when investments are made for the long term. How long should this period be? 7 to 10 years. With such a time horizon, the rupee average works.
But there is a bonus: Do not sell shares when the underlying index (such as the Nifty or the Sensex) is falling – as it did in March-April 20. Don’t forget to read #situation-3 and the conclusion.
Let’s understand what a rupee average is with the help of some concrete examples.
Situation 1: Time frame: 3 years, TAN: Voskhod
Example: HDFC Index Fund – Sensex Plan
The investor has invested for a time horizon of 3 years. During this period, the market was bullish. As a result, the NAV dynamics of the fund were mainly upward. In such a bull market, an investor can achieve an annual return of 12.99%.
Note to self: The overall market trend was upward. The NAV of the fund increased from 128.82 to 242.27 during this period. The investor first systematically bought shares, then booked a profit on 01. December 2014 (in theory), when he thinks the index has peaked.
You should take profits when you think the index has peaked. That’s a rule. How do you know it’s the peak? Construct a curve (as shown above) and observe the trend of the NAV. They would like to see an upward curve.
Situation #2: Time frame: 4+ years, TAN: up and down
Example: HDFC Index Fund – Sensex Plan
The comparison of situation 1 and situation 2 leads to an interesting conclusion. As in condition 1, the investor in condition 2 started investing in January 12. He continued to buy index funds until February 16 (4 years, 2 months).
But when he saw the net asset value steadily decline between March 15 and February 16, his patience ran out. He panicked and sold all his shares in February 16.
He didn’t follow this rule. What’s the rule? To profit from the rupee average, you should only sell when the index (NAV) is rising and shows that it has peaked. Never sell when the index (NAV) is falling.
The fact that the investor did not follow the rule does not mean that, although he held the shares for a fairly long period (over 4 years), he was only able to earn 3.87% per year (see the calculation in the chart above).
Situation #2.2: Time frame: 8+ years, TAN: up and down
Example: HDFC Index Fund – Sensex Plan
This example is similar to situation 2. The only difference is that you have owned the units for a relatively longer period of time (8+ years).
As in situations 1 and 2, the investor started investing on January 12. He kept buying index funds until he was 20. April (8 years, 4 months).
But when he saw the NAV collapse between January 20 and April 20, he panicked. As a result, he sold all his shares on April 20.
Again, the rule has not been followed. To profit from the rupee average, you should only sell when the index (NAV) is rising and shows that it has peaked. Never sell when the index (NAV) is falling….
The fact that the investor did not comply with the rule does not mean that, even though he held the shares for a very long time (more than 8 years), his return was too low (1,46 % APR).
Situation #3: Timeframe: 7+ years, TAN: Elevator (sold above)
Example: HDFC Index Fund – Sensex Plan
This example should be read in conjunction with the previous one (situation 2.2). This example will help us understand the calculation of the average in rupees (in other words, our SIPs).
Note that in this example the NAV of the index fund is on the 12th. January to the 19th. May (7.42) rose from Rs 128.83 to Rs 343.66. The growth rate was 14.18% per year.
Let’s see how our SIP has evolved over the same period. When we as investors see the net asset value of a fund rise by 14.18%, surely we expect similar figures for our investments? You will be surprised when you see the results of the SIP (see the calculation in the graph above).
The investor has accumulated 416,674 numbered units during this period (7.42 years). He decided to sell all his blocks on 02-May’19 (theoretically). The NAV on May 2, 19 amounted to Rs 344.51 crore. The investor can therefore achieve a return of only 6.66% per year.
Although the NAV increased by 14.18%, the actual return to the investor was only 6.66%. Why did this happen? Because what a SIP investor earns is just an average return. Read more: My SIP return calculator.
Hence the origin of the word average in the theory of the average value of the rupee. Investing in SIPs makes our returns average. What does that mean? In the event of a market downturn, this helps to limit our losses. But on the other hand, this will also limit our positive return (6.66% versus 14.18% as indicated above).
What is the output?
There is no gain without pain.
Why invest with SIP? Because it helps us automate our investments, right? In other words, we can say that we accept less pain but expect more results. But in reality, because we are investing on autopilot, our net realized return will be much lower (6.66% versus 14.18% expected – see above).
Where do we apply the average theory of the value of the rupee most often? We make use of it by applying systematic investment plans (SIP) in a mutual fund.
Let’s take an example: HDFC Index Fund – Sensex Plan. Imagine for a moment that it is January 2012 and this is what an expert has told you – …between January 12 and May 19 (7.42 years) the NAV of the HDFC index fund will increase by 14.18% annually.
What are you going to do after this deposition? You invest in this mutual fund and expect a return of 14.18% per year. But since you didn’t have a set amount to invest, you decided to start a SIP.
But first, let’s see what the 14.18% annual return means. Let me explain this with a calculation:
But what is the actual final amount you could have earned with the SIP? The final value was Rs. 1,43,546 crore. So the return is only 6.66%, which is not what you expected (14.12%) – see example situation #3 above.
Thus, we can conclude that rupee averaging (or SIPs) is an investment strategy that should only be used if one dares to take risks. If risk kills us, it’s only to put it into practice. But if our priority is high returns, SIP (rupee average) does not make sense.
How do you use the calculation of average value in rupees?
When should I use the calculation of average value in rupees? I will only use it if I am not confident in my stock investments. What do you mean?
Let’s say today, the 23rd. On January 08, the Sensex dropped from 20,800 to 17,600 in just 12 days (a 15.38% drop). With the Sensex falling, I thought why not pick a few good stocks (to practice value investing). I had some money left, about 89,000 rupees.
But I wasn’t sure which actions would be best. I didn’t know if it was really the bottom of the market either. So I didn’t want to invest the 89,000 rupees in one go. I decided to reinsure, so I chose a SIP in an equity fund.
SIP again? But we’ve already seen that the SIP only provides an average return (see situation #3). Yes, I always recommend using SIP. But the way SIP is used here makes a big difference. Please read on.
As a rule, a bear market lasts no longer than 12 to 14 months. I expect the market to continue to decline over the next 12 to 14 months.
Therefore, I decided to do the following two things with my investments:
- Distribution of resources : I will divide my principal sum (Rs. 89,000) into twelve equal payments of Rs. each. 7,416.6 (Rs. 89,000/12 = Rs. 7,416.6) in the form of a SIP. This means that every month for the next 12 months (from January 23 to December 23, 2008), I will buy units of index funds in which I will invest Rs. 7,416.6.
- Hold it longer: At the end of the SIP, I will own shares for at least the next ten years. So at the earliest I’m going to do my mutual funds on the 23rd. January 2018 sale.
Let’s see how much income this strategy will bring me in the future:
This strategy gives me a return of 10.51% per year. If I had invested my Rs. 89,000 in equal instalments of Rs. 7416 per month for the next 10 years (7416 x 10 x 12 = 89,000), I would have achieved a return of only 6.85% per annum (as of 23 January 18).
Recommended reading:
Frequently Asked Questions
What is the best strategy for a beginner investor?
The best strategy for a beginner investor is to invest in a diversified portfolio of mutual funds, exchange-traded funds (ETFs), and individual stocks.
What are the 4 investment strategies?
There are four investment strategies: 1. Buy and hold 2. Buy and sell 3. Buy and hedge 4. Buy and sell and hedge 1. Buy and sell and hedge
What should a beginner investor invest in?
A beginner investor should invest in a diversified portfolio of stocks, bonds, and mutual funds.
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