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Understanding the techniques of stock market investing

Any emerging investor, would have studied all the avenues of investments and understands cash based investments like FDs have a fixed term and a fixed return but at times the returns do not match inflation. Debt investments like income funds yield a moderate rate of return but again though there is a high level of capital protection the investment may still lose out to inflation.

Equities and equity mutual funds give a superior return over time but can be highly volatile. Gold works well with high inflation but gold allocation is limited. Real estate has been an excellent investment avenue but requires higher investments and liquidity could be a problem.

How to control risk and yet generate a positive return over inflation? The first step would be to determine the ideal asset allocation; this could be derived by deciding what time horizon is and how much volatility.

Further concern about what would be the right strategy for investing quarterly surplus and his cash in bank.

Asset allocation

Asset allocation is the process of diversifying one’s investment with the objective of minimising two risks — that of your wealth not keeping up with inflation, and market volatility.

An ideal asset allocation for an investment with a 3 to 5 year horizon would be:

Investment management

Once chosen asset allocation, needs to understand the techniques involved in managing and further building investment. For quarterly investments, it is recommended that either use rupee cost averaging or value averaging and on his bulk investments needs to rebalance his investment every 3-6 months.

Rupee cost averaging

Rupee cost averaging can be achieved by investing at regular intervals over a period of time. This is often referred to as a ‘systematic investment plan’(SIP). The SIP investor regularly invests, regardless of price movements. Entire capital is not at risk, since it is being ‘drip-fed’ into the market, one bit at a time. That amount buys a different number of units each time; fewer units when the price climbs, and more when it drops. The net result is that after a period of time, has actually acquired more units than the lump sum investor, because able to take advantage of the dips in price. An ideal time horizon for a SIP is 5 years and above.

Value averaging

Value averaging is a more evolved strategy. In this, you adjust or control the amount invested, up or down, to meet a prescribed Target Value of the portfolio. This strategy helps in further lowering the average cost, in a market where the share price/net asset value of the fund fluctuates.

In value averaging, we work backwards, that is, we decide to benchmark the market value of the investments to be achieved and not the fixed outflow as in case of an SIP. For example, if you start to invest Rs 10,000 per month, your value for the second month will be determined by the market value of the first instalment.

Suppose the market value is Rs 10,500 at the beginning of the second month, then your investment for that month is Rs 9,500. For your third month, assuming your market value has dropped to Rs 19,000, the instalment will be Rs 11,000. This balancing act will continue every month with proper monitoring and management.

Compared with rupee cost averaging from SIP, you ensure that you buy fewer units when the market appreciates and more units when the market slumps. Value averaging also involves a bit of profit booking when markets are abnormally bullish.

Rupee cost averaging v/s value averaging

In the illustration for the SIP, an amount of Rs 10,000 has been invested every quarter from September 10, 2005, to June 10, 2008, in an equity diversified fund. For value averaging the investment is made to appreciate by Rs 10,000 at the same intervals as the SIP by decreasing and increasing the fresh entry and even profit booking based on the upward and downward movement of the investment. Going by the values of the chart and considering the current behaviour of the market.

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