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BW Businessworld

Dollar Cost Averaging: More Bang To The Buck

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Forget the bulls and bears, stockmarket investors are like hares and tortoises. There are those who go racing for spectacular gains, and others who do the slow and steady route. For the latter, rupee cost averaging is an investing technique that allows you to spread your purchases over a period of time, rather than make one single large bet. You could, for instance, invest a fixed sum of money each quarter, and buy the same stock; the idea here is to smoothen out market volatility in prices by investing over a number of periods.
What would such an approach do? For one, it spreads the cost of acquisition over time, and provides some insulation from market price changes. In other words, you work your way into a position. Second, it avoids investing too much when the market is high and investing too little when the market is low. For practical purposes, think of the approach the way you put money in your provident fund, just more of it.
The table provides a hypothetical picture of how rupee cost averaging works. We have assumed that a person has Rs 8,000 at his disposal and wants to keep invested for a period of two years, but wants to play it safe. He has two options: invest a lump-sum amount of Rs 8,000 at Rs 120 per share on January 2006. So, he would be buying 67 shares and selling them at the end of two years at Rs 50 per share. Thereby, making a loss of 58 per cent.

Or, he can follow the rupee cost average method and invest Rs 1,000 every quarter for two years, and reduce his risk. Under this method, he would be buying 105 shares by investing a total sum of Rs 8,000, at the end of two years. This would give him a return of negative 34 per cent if he sells the shares as of October 2007 at Rs 50 per share, which is much less than 58 per cent. It is quite evident that this method is safer than investing a lump-sum amount.
What if the market and the stock price goes up? The return would be positive but would be less when compared to lump-sum investment. As the price increases, the number of shares purchased decreases. In our example, at the end of two years the person would have 64 shares and make a profit of 35 per cent. Which is much less than 67.50 per cent, a return he would have generated if the entire sum were invested at the beginning.
The rupee cost average approach also works well with mutual funds. The expense is same in case of both lump sum investment and fixed installments, but, in the later case, the expense is spread evenly.
Many mutual funds waive their required minimums for investors who set up automatic contribution plans (plans that put rupee cost averaging into action). This enables low-wage earners to invest a nominal amount on a regular basis without worrying about the impact of trading costs. While small contributions may not seem impressive at first, they enable investors to save, and can really add up over time.
While dollar cost averaging can help limit the downside of a worst-case scenario of an immediate drop in asset value after the lump sum is invested, market research has shown that such drop-offs are relatively rare compared to the strong emphasis the strategy puts on avoiding them. A better approach would be to increase the amount of investment every quarter. The increasing investment approach would not only reduce losses when the scrip price goes down but also increase profits when the price goes up as compared to rupee cost averaging.

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(Businessworld Issue 25 Feb-3 Mar 2008)

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