Buying stocks on dips or continuing SIPs helps in reducing average cost.
Aarav Sharma got Rs 1.8 lakh as performance bonus in November and decided to invest this money in the markets once it started correcting. He believed , it was only a matter of time before maket analysts’ estimates of the Sensex touching 23,000 in the near term would come true. During the time, his financial advisor asked him to adopt a staggered approach to investing in the equity markets, He chose a weekly investment strategy instead of investing a lump sum money in the markets.
However, when the markets showed no signs of a solid recovery and came nowhere near the expected mark, Sharma’s started worrying. How would his money grow if the market continued to decline Was his strategy the right one?
Facts
Sharma had selected the ‘Reliance Regular Savings Fund - equity option’ for investing his mid-term bonus and chose a systematic transfer plan with the weekly transfer option to the equity fund over the next 12 weeks beginning December 1, 2010.
Over the next 12 weeks, he invested Rs 15,000 each week. As table one shows, at the end of the first month (December 2010), his total amount invested was Rs 60,000 and he had 2,344 units credited to his mutual fund account. His investment remained the same in the following two months. But thanks to a falling market and downward averaging, the number of units credited to his account increased substantially to 2,427 and 2,670 units for January and February 2011 respectively.
| Table 1: Downward Averaging | ||
| Month | Amount invested | Units Allotted |
| Dec-10 | 60,000 | 2,344.67 |
| Jan-11 | 60,000 | 2,427.36 |
| Feb-11 | 60,000 | 2,670.14 |
| As on 28-02-2011 | 180,000 | 7,442.18 |
This is a classic example of downward averaging, where his investments continued for approximately three months even as the markets slid.
Like most retail equity investors, Sharma too was following the herd and thus was worried about his investments because with the markets falling, many of his friends had stopped making any further investments in equity. They preferred playing the ‘wait-n-watch’ game and advised him to follow suit.
Faced with a doubt, Sharma wanted to understand whether averaging one’s cost of investment in a market downturn could be better as compared to averaging in a market upturn.
Analysis
We extrapolated several possibilities to explain to Sharma to explain how his investments would work out in different possible scenarios.
At this juncture, when the indices have corrected by close to 15 per cent, there were only two possibilities. One is that the markets would further slide. The second possibility is that the markets would move northwards.
If the markets continued to fall from its current positions, Sharma’s investments would continue in the downward averaging mode. But, if the equity markets start looking up, then we need to consider three more alternatives that could take place. One possibility is that the fund recovers at the same average (which is calculated at 1.43 per cent each week for the data recorded from December 1, 2010 to February 4, 2011) as it corrected during the last 12-13 weeks. The other possibilities are that there is a lower or higher average, depending on how the market moves.
As mentioned earlier, it has been assumed the net asset value (NAV) would continue to correct by 1.43 per cent over the last two weeks of February 2011 and the uptrend would continue for the next three months - March, April and May 2011. These assumptions help in bringing parity between the dates of investment in a down-turn and up-turn.
While it is not possible to pin point the direction the market is likely to take at any given point, a probable scenario was drawn up to help Sharma understand the other side of downward averaging, that is, upward averaging (Table 2).
| Table 2: Probable Upward Averaging | ||||
| Month | Amt | Units* | Units** | Units*** |
| Mar-11 | 60,000 | 2,678.85 | 2,707.31 | 2,641.92 |
| Apr-11 | 60,000 | 2,530.87 | 2,601.67 | 2,440.72 |
| May-11 | 60,000 | 2,391.10 | 2,500.16 | 2,254.85 |
| As on 30-05-2011 | 180,000 | 7,600.82 | 7,809.13 | 7,337.51 |
| *Weekly growth at 1.43 per cent ** Weekly growth at 1 per cent *** weekly growth at 2 per cent | ||||
Suppose Sharma continued to invest Rs 60,000 in March, April and May 2011 when the markets were moving upward, his number of units would reduce considerably. So when the fund’s weekly NAV is growing at 1 per cent, he has 7,809 units, at 1.43 percent his total units add up to 7,600 and at a weekly growth of 2 per cent, it is 7,337 units.
Observations
As may be observed from Table 3, as long as the markets recover at the same pace or lower pace as the downturn, Sharma may be at a disadvantage as compared to his friends, who choose to average their investments during the upturn. It may be noted that the difference in valuation is only to the extent of two to five per cent, which is negligible during times when markets corrects close to 15 per cent. However, if the fund’s NAV recovers at a faster pace than its southward movement, Aarav’s investment decision proves to be smarter than his friends.
| Table 3: Comparison between Downward and Probable Upward Averaging | |||
| A | B | ||
| Weekly NAV growth rate* | Units as per Table 1 | Units as per Table 2 | Difference (A/B) |
| Same at 1.43 | 193,522 | 197,648 | -0.02 |
| lower at 1 | 199,428 | 209,261 | -0.05 |
| higher at 2 | 208,132 | 205,205 | 1% |
| * in per cent | |||
Looking back in time
Let’s check what the fund history has to say. The fund’s weekly NAV movement during the downturn between April and May 2010 worked out to -0.53 per cent. On the other hand, results for the NAV movement recorded between June and July 2010, when the markets were northbound, showed a weekly appreciation of 1.06 per cent, which is exactly double the rate of downturn.
No doubt, we have no clue as to when the markets could reverse its direction and whether or not history repeats itself, but this limited exercise does help in understanding that people who average their investments while the markets are moving down would definitely not be losers.
(Disclaimer: Reliance Regular Savings Fund has been randomly picked for this analysis, it should not be construed as an advice for fund selection)
The writer is a certified financial planner
