Timing is never more crucial than when you decide to enter the stock market. The difficulty is, as you ogle a juicy-looking stock, you are armed only with the benefit of hindsight. And even then no one, not even an expert, can know when we are in the trough of a market — the perfect buying opportunity.
But you don’t have to have a crystal ball if you follow the concept of rand cost averaging (RCA). In English, this means putting aside a set amount of money each month into a stock or mutual fund. It is a simple and effective investment vehicle that can shield the investor against the vicissitudes of the market. Instead of buying into a stock as a lump sum, the investor works his way into a good position by buying small over a period.
When the market is on a high, your monthly rand allocation buys you fewer shares and when the market is low, your rands buy more shares. By the end of a period, one would have paid the average share price, avoiding the mistake most people make of buying during the highs.
Hugo Lambrechts, a professor in the department of accounting and finance at the University of Pretoria, says one of the reasons investors attempt to time their investments is because they want to invest a lump sum. In many ways in RCA the investor goes against the market, sometimes buying while the price is falling. When people invest lump sums, they are using the history of the performance of the stock.
“They try to put their money into last year’s winner,” explains Lambrechts.
He says one of the problems with lump sums is that people tend to withdraw them, usually at the wrong time, leading to volatility in the market. The one advantage of a lump sum is when the share is really running. However, one can never be sure if the market is at its high or its low. “If the market goes down after you have invested a lump sum, you will come second.”
For instance, Joe wants to invest in a unit trust. He has R1 500 that he could use to buy his chosen unit trust, which has performed very well recently. Rather than invest the lump sum, he decides to invest R500 for three months.
In the first month the unit costs R1. This means he can buy 500 units. In the second month, the unit trust fund is still running hard and has gone up to R1,10. Now he buys 454 units. In the third month there is a correction and the unit price falls to 90c. Now he can buy 555 units. At the end of the period he has accumulated 1 509 units. If he had invested the lump sum he would have purchased 1 500 units only.
Over time, volatility will work to the advantage of the RCA investor. Rather than crying into your coffee when the market corrects, you recognise that your next monthly instalment will be buying at a lower price.
By using this technique, an investor is able to stave off the urge to buy too many shares at once, something that he would certainly do if he was investing a lump sum. It also prevents getting caught up in the investment hype around overheated markets. Another advantage with this technique is that a smaller price increase is needed to cancel any losses one may have incurred as you have been buying at different prices.
Apart from creating more stability in the market, this method encourages a culture of saving. The amount that one can contribute may be so small that one may hardly notice it. For example, investing R200 a month is equivalent to a night on the town. Small monthly amounts accumulate into larger lump sums. Lambrechts says that RCA also inculcates a sense of discipline as you are less likely to stop a debit order. Lambrechts advises choosing a good fund manager, and then investing and forgetting about the investment.
He advises minimum investment periods of between five and seven years; one could make this longer if you want to make savings for retirement.
“You can do it as a short-term savings vehicle but the market can be volatile. Three to five years may be too short to make a return.”