Shaun van den Berg, Head of Client Education PSG Wealth
With market volatility the order of the day, rand cost averaging, or phasing your money into the market, is a strategy to reduce risk.
The price that you pay for any investment forms the basis for your future returns. Ideally, you want to invest when prices are low and sell when they are high to maximise your return. The challenge is that share prices can and do often change on a daily (and even hourly) basis, particularly at the moment.
If you are investing a lump sum of money, how do you avoid a situation where you invest your money in shares (directly or via a unit trust that invests in shares) one day, only to be exposed to the risk of the price dropping the next day? How do you ensure that you minimise this risk as far as you can and get the proverbial “most bang for your buck”?
The best way to take advantage of fluctuating share prices is to use rand-cost averaging. Rand-cost averaging helps you get the best average price over a period of time.
Put it this way: if you were doing a long-distance trip, say from Cape Town to Johannesburg, and if our petrol prices were like Australia’s (where the price can vary from station to station), would you rather:
- Fill up the tank in one go in Cape Town, or
- Determine the locations of the different petrol stations on your route and plan a disciplined series of stops to buy petrol along the way in the hope of smoothing out the price so that you end up paying an average between Cape Town and Johannesburg?
The prudent thing to do would be to choose option 2 – spreading out your purchases across a number of different petrol stations. This is exactly what rand-cost averaging is: averaging out the rand cost of your investment. The only difference is that instead of buying petrol, we are talking about investing in equities. In the context of equity investing this could be buying a batch of shares on a regular basis, or scheduling your investment into a unit trust by making regular payments or buying units over a period of time.
A simple illustration of the principle of rand-cost averaging:
|Month||Investment (R)||Unit Price (R)||Units Bought|
|Total cost (7 x 500)||3500|
|Current value (latest total units x 1.10)||3609|
|Average Unit Price||0.96|
Over time, market fluctuations can be smoothed out because when the market price is down you will be able to buy more shares or units in a unit trust. Conversely when the market is up, you won’t be able to afford as many shares or units. The theory is that what you will end up with will be the best average price for the shares or units you buy.