Smoothing out volatile returns
As I've previously written, the most effective way to protect thebuying power of your wealth for the longer term is to be invested in awide spread and have a diversified portfolio of real assets such asequity funds, fixed interest bond funds and property funds. In thisarticle I will explore a technique known as Pound Cost Averaging whichcan be used to lower risk by gradually investing in real assets.
One of the problems in volatile times such as we are currentlyexperiencing is that the reaction of many investors is to stay in cashrather than to take what they consider to be short term risk. Assomeone once said to me, 'the long term is made up from a number ofshort term periods added together', which is a good explanation of whymany investors end up staying in cash for the longer term - they don'tthink that it's ever the right time to invest actively in markets.
In certain respects, moving into assets where the capital values canfall as well as rise is a brave move compared to choosing assets thathave no capital volatility, but history shows that over the longer termyou get more ups than downs. It's the difference between the two whichallows you to protect your capital from inflation and which cangenerate income. Cash in the bank will never have any ups so you don'tget any inflation proofing to your capital above the interest youreceive.
The cost of delay
Invariably many investors don't take what they see as a plunge into real assets and end up in one of two different situations.
The first is that they leave it and leave it and leave it… to theextent that by the time they can actually see what the cancer of longterm inflation has done to their capital, it's too late. Alternativelythey then need to take a higher risk than they are comfortable with totry and restore their buying power. While inflation in Europe isfalling, so are interest rates, so savers are in no better positionthen when inflation was higher. In fact they may be worse off,especially when you bring the Sterling/Euro exchange rate into theequation.
The second situation is when people eventually invest because theyfind the confidence, but then follow an unfortunate but predictablepath. As markets rise, investors become less nervous and begin toconsider investing in real assets. As the markets continue to improvethey then gain enough confidence to invest. However, if you look backover history you'll see that often, the point where most people areinvesting is the point where markets have reached the top and are aboutto fall.
Unfortunately, we don't know what the top of a market cycle is untilafter it's fallen. The investors who'd waited to build up sufficientconfidence to invest at what turned out to be the top of the market seethe value of their initial investment fall. If the falls continue, theydisinvest, move back to cash and swear never to invest again.
Again, as history tells us, they shouldn't have disinvested and realised loses because inevitably markets do rise again.
A good example of the behaviour of real assets is in the UK housingmarket. If someone had purchased a property at the average UK houseprice in autumn 1989 they would have paid £62,782. By winter 1995 thatproperty was worth £50,930. By winter 2000, it was worth £81,628. Bywinter 2005 it was worth £157,387. The property value reached its peakin autumn 2007 at £184,131 and in autumn 2008 was worth £165,188.
Three questions for you: (1) Would you have sold the property inwinter 1995 at a big loss? (2) If it wasn't your own home would youhave been tempted to sell? (3) Would you now be happy with your overallreturns over the period if you'd kept the property?
The same type of pattern can be seen in other asset classes such asequities. Equities however have the benefit of being freely liquid soyou can encash them at any time, either fully or partially. Bricks andmortar are less liquid and you'll also need to spend time and money onthe upkeep.
The property scenario is an example of the type of behaviour of realassets. Investors should look to diversify across a number of sectorsto reduce the risk to a particular asset class and invest through fundsrather than direct holdings.
So how can people invest early enough but without taking on too much risk?
Although logic suggests this is a good time to invest in real assetsgiven the low market levels and analytical indicators, I fullyappreciate that some investors still feel nervous about committingfunds into them. There is a way to reduce risk which is known as PoundCost Averaging - investment industry jargon for moving money graduallyfrom low risk/low return assets such as cash into real assets such asequities.
The example below demonstrates this technique. It uses three hypothetical potential scenarios for a 12 month period.
Scenario 1 - the real asset's value increases by 8%, i.e. 2% per quarter (simple).
Scenario 2 - the real asset's value increases by 2% in the 1stquarter, falls by 2% in quarters 2 and 3 and increases by 2% in quarter4.
Scenario 3 -the real asset's value decreases by 8%, i.e. 2% per quarter (simple).
The table below compares investing a single lump sum of £400,000 inthe real asset at outset to the use of pound cost averaging - i.e.investing £100,000 at outset and a further £100,000 in each subsequentquarter until you are fully invested.
Single lump sum results Pound cost averaging results
Scenario 1 £432,000 (+8%) £420,000 (+5%)
Scenario 2 £400,000 (0%) £400,000 (0%)
Scenario 3 £368,000 (-8%) £380,000 (-5%)
By phasing investments from low risk/low return assets into realassets over a period of time, you can reduce risk in the event thatmarkets have not reached the bottom when you invest (although it doescome at the cost to the gain you could have made should markets havealready reached the bottom). In respect of scenario 3, the effect ofpound cost averaging has reduced the first year loss by 37.5%.
Pound cost averaging is a principal of phasing money into realassets. You can choose your time frames, eg, whether to invest everymonth or more or less than 12 months. The concept can also work wellfor investors who are currently sat on unrealised losses from realassets but still have cash on deposit.
As always, you should only seek professional authorised and regulated advice from a company such as Blevins Franks.