What is Cost Averaging?

In a marathon, participants are advised to go easy on sudden bursts of high speed during the race, especially at the beginning. This may sound confusing. How can one win such a long distance without speed? However, running at full speed would be pointless if the participant loses stamina mid-way. 

Similarly, investors gain when they are steady and consistent even in volatile situations instead of looking at high-speed sprints. We all have heard that one should buy more when the market is low and reap profit when the market is high. However, with limited time, resources, information, and skillset it gets very difficult to time the market and actually buy and sell with every dip. In fact, there are costs such as brokerage, taxes, and STT involved when you buy and sell with every small change. These costs would eat into your profits. So what is the easiest way to make use of the saying and buy more when markets are at a low and less when markets are at a high? 

 SIP (Systematic Investment Plan) is one of the best modes to invest in such a situation. Let us understand this better with an example.

What is cost averaging? 

The concept of cost averaging lies in averaging out the cost at which you buy units of a Mutual Fund. it guides the investor to - buy- low and sell- high’. However, at times an investor ends up doing just the opposite. By investing on a fixed schedule, you avoid timing the market and figuring out the exact best time to invest. Cost averaging helps you to take advantage of market volatility. 

How does SIP help with averaging?

Take a look at the following table to understand the concept better:

DateNAVUnitAmt
Dec-19524.649.5303455000
Jan-20525.279.5189145000
Feb-20509.319.8172045000
Mar-20468.7710.666215000
Apr-20348.5114.346795000
May-20409.9612.196315000
Jun-20405.412.33355000
Jul-20429.2911.647145000
Aug-20446.7211.192695000
Sep-20467.3510.698625000
Oct-20449.911.113585000
Nov-20455.4610.977915000
Dec-20522.399.5713935000
Jan-21560.578.9194935000

Total Investment: INR 70,000

Total Number  of Units: INR 153

Profit: INR 15,504

 

If the same amount i.e INR 70,000 was invested by lump sum route in December 2019, one would have earned a profit of only INR 4,794 in Jan 2021.

In the above example, we can see that SIP helps us to reap more profit in comparison to lump sum due to cost averaging. We often hear people saying buy more when the market is down, but one cannot time the market and invest according to it. 

 

You can refer to the following articles to know more about SIPs: 

SIP Impact: Well Illustrated

Timing the market for your SIP investments?

Should I pause/stop my SIP?

 

Wealthcafe Advice:

We recommend you invest based on your asset allocation. As said earlier, one cannot time the market, however asset allocation will help you to buy and sell accordingly. If the ratio of equity: debt changes by 10%  it is time to revisit and rebalance your portfolio. This will help you to buy- low and sell- high. You can read this article - How am I investing in current times - Akruti Agarwal- to understand how asset allocation helped me to earn profit during a pandemic situation. 

 

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