Remember all those Economics lessons in school? It's time to use those fundamentals. If you recall the law of demand, it says that a higher quantity of a commodity is purchased when it is least expensive. Conversely, the demand tends to reduce when the price of the commodity rises.

However, most of the investors end up doing just the opposite. They start buying when the markets are rising, hoping to cash-in on the rise and suddenly redeem upon a slump, worried about further losses. Ultimately, their average cost of investing increases and returns fall.

An SIP investment allows you to take the advantage of rupee-cost averaging in an automated manner. And let's face it, aren't we all too busy to manually monitor the rise and fall?

A smart way of investing in mutual funds is through an SIP or Systematic Investment Plan. SIPs allow you to invest a certain fixed amount at regular intervals of your choice — monthly, or quarterly.

In case of an SIP, the money gets debited from your bank account on a standing instruction and gets invested into mutual fund schemes. The number of units that get allocated depends on the Net Asset Value, or NAV, on that day.

For each instalment of investment, additional units of the scheme are purchased at the market rate and added to your account. Over a period of time, since units are purchased at different rates, the investors get the benefit of Rupee-Cost Averaging.

In the absence of a Systematic Investment Plan, one would have to apply one's mind to time one's entry and exit from the market. In volatile markets, this becomes difficult. By investing on a fixed schedule, you avoid the complex or even impossible duty of trying to figure out the exact best time to invest. Cost averaging allows you to eliminate this uncertainty.

An SIP investor, while investing every month, would end up buying more units when markets go down and buying fewer units when the market goes up. It would help in achieving a lower average cost per unit.
Suppose you are investing Rs 1,000 per month in an equity SIP. This is how the cost of your investment will be over a year:

Time (months) Amount invested (rupees) [A] NAV per unit (rupees) [B] Units purchased [A/B]
1 1,000 23 43.5
2 1,000 21 47.6
3 1,000 22 45.5
4 1,000 19 52.6
5 1,000 16 62.5
6 1,000 17 58.8
7 1,000 17 58.8
8 1,000 20 50.0
9 1,000 21 47.6
10 1,000 19 52.6
11 1,000 25 40.0
12 1,000 24 41.7
TOTAL 12,000   601

Over a period of 12 months, you would have invested Rs 12,000.

  • Normal Average NAV per Unit over 12 months = (Total of NAV per month/12) or Rupees 20.33
  • For an investment of Rs 12,000, you would have purchased 601 units. So the effective Average cost per unit is calculated as follows: Rs 12000/601 units =   Rs 19.96 (lower than average NAV of Rs 20.33).

Therefore, the Average Cost per Unit will always be lesser than the Average NAV per unit, regardless of the market movements.

The concept of rupee cost averaging lies in averaging out the cost at which you buy units of a mutual fund. The equity markets have always been volatile reflecting the ups and downs of the economy.

In an SIP investment, the factor of volatility is reduced and as a result, the overall gains will also increase. Rupee cost averaging works out best in choppy markets but is useful even when the markets are in a bull run. It essentially helps you buy less when the markets are expensive and buy more when the markets are cheap.

An SIP is an easy way of doing this thanks to the benefit of rupee cost averaging.

 

Disclaimer: Mutual Fund investments are subject to market risks, read all scheme related documents carefully.

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