17 April 2009 Issue #511

*** Lower your purchase price…

*** Who needs rand cost averaging…?

*** A strategy for today's market… and more...

From the paper mountain of Julie Brownlee

Dear Investment Academy Reader,

Today I thought we'd take a welcomed break from the fast paced world of trading and think long-term strategy instead. Dr Scott Brown is with us today to guide you through the wonder of rand cost averaging. Scott is the education director at our sister publication in the US. If you're thinking about buying your first share - read this first! If you're in your early twenties, this couldn't come at a better time for you. The earlier you start the better!

So, without wasting another second, it's over to Scott...

The wonders of rand cost averaging

Many know rand cost averaging is a series of equal rand investments made at regular intervals. But it can also be used as one of the most powerful ways to build wealth.

I know a beautician named Sharon who ran a shop out of her house in a small mountain community. Living off of her husband's salary, she took what she made from cutting hair and invested it – through rand cost averaging.

Those haircuts added up. She and her now retired husband are living in their dream home.

Quite simply, rand cost averaging is a straightforward and functional strategy that can be used by anyone from investment experts to novices. Instead of investing a lump sum all at once, you invest equal amounts at regular intervals over a period of time.

But there's more to this strategy than meets the eye...

It's what the experts do

Rand cost averaging is used by large unit trust funds and institutions that have hefty portfolios already, or individuals - like my friend above - who save and invest with small, consistent amounts. In short, everyone can use this timeless strategy.

If you ran a unit trust fund or large institutional asset pool, you invariably would have to buy stocks in bigger quantities. But, for example, if you place an order for one million shares, everyone else would know that you're buying.

They’d rush to buy shares and drive up the price before your purchase went through.

To prevent this, many professional traders and funds will make numerous smaller purchases when building up a large position in a stock. This prevents anyone from knowing how much you're buying. And because the amounts are spread out, it lowers the chance that they've timed their purchase incorrectly.

For investors who may not have the time, energy or knowledge to time their transactions, this strategy can lower your average cost per share by spreading out your purchases.

Lower your purchase prices

For example, let's use a smaller investment amount to illustrate – R5,000. If you invested R5,000 into an index with a R50 net asset value (NAV) at the beginning of the year, you've purchased 100 shares.

But, let's say you spread those purchases out in R417 monthly increments. And let's say that index has been fluctuating over the course of the year with a range of R41 to R57.

Here's how it looks...

Because of the choppiness of the share price, your rand cost averaging strategy allowed you to purchase 4.95 more shares during the same period with the same investment amount. Imagine if you could increase all your investments by 4.9%...

Rand cost averaging reduces the risk of buying your investment at its highest point. By making multiple purchases, you're bringing your average cost per share down.

In addition to simply being a way to lower you costs, it's practical as well. Very few of us start the year with the full amount of funds we have to invest over that year.

Start with a consistent amount (many online brokerages will allow smaller transactions) and set up a regular investment schedule. For newer investors, it's one of the easiest and best ways to build great wealth.

For more experienced investors looking to get back into the market, it's the perfect way to rebuild or start new positions without a confirmation that we've hit a bottom or not.

It should be a lesson for the millions of South Africans who believe they can't start investing until they have a large amount saved up. You can start small, you can start smart - and you can come out on top, just like Sharon.

The other side to rand cost averaging

There are some limitations to rand cost averaging. And many of its opponents are quick to point them out. As a strategy, rand cost averaging works best in mixed, uneven or choppy markets.

If you were going into a sharp downturn, the best strategy would be to wait as long as possible before getting back in. On the other hand, if the market was going to move straight up, you’d want to put all of your money in as quickly as possible.

But the fact of the matter is that no one knows what the markets will do tomorrow, next week, next month or any period of time in the future. So as intelligent investors, we need to choose a strategy that'll allow us to maximise our returns – regardless of the JSE’s direction.

It's why rand cost averaging is so flexible and appropriate for the market conditions right now.

It can be done on any timeline. Some investors cost average for a day, others for a year. You choose the timeline that's most appropriate for your needs. The net result is that your average cost should equal the average price during that period.

And lower costs mean higher profits!

It all starts with education,

Dr Scott Brown
For the Investment Academy