Smoothing out volatile returns

By BILL BLEVINS [email protected]

Bill Blevins is the Managing Director of Blevins Franks. He has specialised in expatriate investment and tax planning for over 35 years. He has written books and gives lectures on this subject in Southern Europe and the UK

The most effective way to protect the buying power of your wealth for the longer term is to be invested in a wide spread and have a diversified portfolio of real assets such as equity funds, fixed interest bond funds and property funds.

This article explores a technique called Pound Cost Averaging which can lower risk by gradually investing in real assets.

One of the problems in volatile times is that the reaction of many investors is to stay in cash rather than take what they consider to be short term risk.

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 the extent that by the time they realise what damage long term inflation has done to their capital, it’s either too late or they then need to take a higher risk than they are comfortable with to try and restore their buying power.

The second situation is when people eventually invest because they find the confidence, but then follow an unfortunate but predictable path. Investors wait until markets have risen for a while before gaining enough confidence to invest. However, if you look back over history you’ll see that often, the point where most people are investing is the point where markets have reached the top and are about to fall.  

We don’t know what the top of a market cycle is until after it’s fallen. The investors who had waited to invest at what turned out to be the top see the value of their initial investment fall.  If the falls continue, they disinvest, move back to cash and swear never to invest again.

Again, as history tells us, they shouldn’t have disinvested and realised losses because inevitably markets do rise again.

A good example of the behaviour of real assets is in the UK housing market. If someone had purchased a property at the average UK house price in autumn 1989, they would have paid 62,782 pounds sterling. By winter 1995 that property was worth 50,930 pounds. By winter 2000, it was worth 81,628 pounds. By winter 2005 it was worth 157,387 pounds. The property value reached its peak in autumn 2007 at 184,131 pounds and in autumn 2008 was worth 165,188 pounds.

Three questions: (1) Would you have sold the property in winter 1995 at a big loss? (2) If it wasn’t your own home would you have been tempted to sell? (3) Would you now be happy with your overall returns over the period if you’d kept the property?

The same type of pattern can be seen in other asset classes like equities. Equities however have the benefit of being freely liquid so you can encash them any time, either fully or partially. Bricks and mortar are less liquid and you’ll also need to spend time and money on the upkeep.

Investors should look to diversify across a number of sectors to reduce the risk to a particular asset class and invest through funds rather than direct holdings.

So how can people invest early enough without taking too much risk?

Although logic suggests this is a good time to invest in real assets given the low market levels and analytical indicators, I appreciate that some investors still feel nervous about committing funds into them. There is a way to reduce risk which is known as ‘Pound Cost Averaging’ – investment industry jargon for moving money gradually from low risk/low return assets such as cash into real assets such as equities.

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 eight per cent, i.e. two per cent per quarter (simple).

Scenario 2 – the real asset’s value increases by two per cent in the 1st quarter, falls by two per cent in quarters 2 and 3 and increases by 2 per cent in quarter 4.

Scenario 3 –the real asset’s value decreases by eight per cent, i.e. two per cent per quarter (simple).

The table below compares investing a single lump sum of 400,000 pounds sterling in the real asset at outset to the use of pound cost averaging – i.e. investing 100,000 pounds at outset and a further 100,000 pounds in each subsequent quarter until you are fully invested.

By phasing investments from low risk/low return assets into real assets over a period of time, you can reduce risk in the event markets have not reached the bottom when you invest (although it does come at the cost to the gain you could have made should markets have already reached the bottom). In respect of scenario 3, the effect of pound cost averaging has reduced the first year loss by 37.5 per cent.

Pound cost averaging is a principal of phasing money into real assets. You can choose your time frames, eg, whether to invest every month or more or less than 12 months. The concept can also work well for investors who are currently sat on unrealised losses from real assets but still have cash on deposit.

As always, you should only seek professional authorised and regulated advice from a company such as Blevins Franks.

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