Rand cost averaging smooths out market bumps
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Rand cost averaging is a wealth building strategy that involves investing a fixed amount at regular intervals over a long period.
When it comes to implementing investment strategies based on rand cost averaging, there may be no better investment vehicle than a collective investment such as a unit trust or an exchange-traded fund - the structure of these funds almost seems to have been designed with rand cost averaging in mind.
It involves investing a fixed amount at predetermined intervals. The easiest way of doing this is to set up a bank debit order timed to coincide with your salary. This means that you put saving at the front of the queue - and not the back as it is so tempting to do.
The problem with waiting to see how much money is left over at the end of the month is that generally there isn't any! Taking away the decision to save each month by automatically investing removes the temptation to spend it on something else.
The amount of money invested monthly remains the same over time, but the number of units purchased varies based on the market value of the underlying shares.
When the markets are up, you buy fewer shares per rand invested because of the higher cost per share. When the markets are down, the situation is reversed and you purchase a greater of number of shares.
It's a great way to invest because you buy more shares when the cost is low, so you get an average cost per share over time, meaning you don't have to invest the time and effort to monitor market movements.
While small contributions may not seem impressive at first glance, they enable investors to adopt the habit of saving, and can really add up over the course of a lifetime thanks to compounding.
Albert Einstein is reputed to have called compounding the eighth wonder of the world. Compounding takes place when an asset has generated earnings, which are then reinvested to generate their own earnings.
Rand cost averaging works well for those who do not have huge amounts of money to invest and even for the wealthy.
If this was invested all at once, the investor would face the risk of declining financial markets taking a huge chunk out of the capital.
Rand cost averaging offers the perfect solution to an investor's dilemma.
To facilitate a long-term strategy for investing large sums of money, most collective investment companies' funds offer investors the ability to put a lump sum into a money market fund from which predetermined amounts are automatically invested into a designated higher-risk unit trust each month.
It's a convenient, cost-efficient solution that mitigates concerns about investing a large sum at the wrong time.
Regardless of the amount invested, rand cost averaging is a long-term strategy. While the financial markets are in a constant state of flux, they tend to move in the same general direction over a long time.
Bear and bull markets can last for months, if not years. Because of these trends, it is generally not a particularly valuable short-term strategy.
The markets, even though they have bad days or even bad years, tend to go up over time. When you invest a set amount each month, you buy fewer shares when the market is high and more shares when it's low.
Consider, for example, investing 10 times in a unit trust over a month.
While it is unlikely that the purchase price of the unit trust will be identical for each transaction, it is also unlikely that it will differ significantly over such a short time frame.
On the other hand, over the course of a market cycle lasting five or 10 years, and including a bull and a bear market, the price of a security is likely to change significantly.
Rand cost averaging will ensure that your average cost per unit represents both the benefits of a bull market and the discounts of a bear market.
If anyone was able to predict when the market had bottomed, there would be no need for rand cost averaging. But as we cannot, it provides a great way of smoothing out the bumps of the market.