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 assets such as equity funds, fixed inte
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 assets such as equity funds, fixed interest bond funds and real assets (example property funds). This article explores a technique known as Pound or Euro Cost Averaging which can be used to lower risk by gradually investing in equities or other assets over a period of time.
One of the problems in uncertain times is that the reaction of many investors is to stay in cash rather than take what they consider to be short term risk. Considering the long term is made up of many short term periods added together, many investors end up staying in cash for the longer term – they don?t think that it?s ever the right time to invest actively in markets.
In certain respects, moving into assets where the capital values can fall as well as rise is a brave move compared to choosing assets that have no capital volatility, but history shows that over the longer term you get more ups than downs. It?s the difference between the two which allows you to protect your capital from inflation and which can generate income.
Cash in the bank will never have any ups so you don?t get any inflation proofing to your capital above the interest you receive. And as we?ve seen over the last few years, you cannot rely on bank interest rates as they can stay very low for a very long time.
The cost of delay
Invariably many investors don?t take what they consider to be a ?plunge? into real assets.
Some leave it and leave it and leave it? until by the time they can actually see what the cancer of 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.
Other investors do find the confidence to invest, but only after markets have been rising for a while. Unfortunately 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?d waited to build up sufficient confidence to invest at what turned out to be the top of the market see the value of their investment fall. If the falls continue, they disinvest, move back to cash and swear never to invest again.
However, as history tells us, they shouldn?t have disinvested and realised losses because, if you are invested for the longer term, inevitably markets do rise again.
A good example of the behaviour of real assets is in the UK housing market. If you?d purchased a property at the average UK house price in autumn 1989 you?d have paid ?62,782. By winter 1995 that property had fallen to ?50,930. The property value then recovered to reach its peak of ?184,131 in autumn 2007. In winter 2010 was worth ?163,244.
Three questions for you: (1) Would you have sold the property in winter 1995 at a big loss? (2) If it wasn?t your actual home would you have been tempted to sell in 2007? (3) Would you now be happy with your overall returns if you?d kept the property until the end of 2010?
The same type of pattern can be seen in other asset classes such as equities.
So how can people invest new capital without taking on too much risk?
There is a way to reduce risk known as Pound or Euro Cost Averaging – moving money gradually from low risk/low return assets such as cash into equities and/or other investment assets.
The example below demonstrates this technique. It uses three hypothetical potential scenarios for a 12 month period.
Scenario 1 ? the asset?s value increases by 8%, i.e. 2% per quarter (simple).
Scenario 2 ? the asset?s value increases by 2% in the 1st quarter, falls by 2% in quarters 2 and 3 and increases by 2% in quarter 4.
Scenario 3 ?the asset?s value decreases by 8%, i.e. 2% per quarter (simple).
The table below compares investing a single lump sum of ?400,000 at outset to the use of Pound Cost Averaging – investing ?100,000 at outset and a further ?100,000 in the subsequent three quarters.
Single lump sum results: ?432,000 (+8%)
Pound cost averaging results: ?420,000 (+5%)
Single lump sum results: ?400,000 (0%)
Pound cost averaging results: ?400,000 (0%)
Single lump sum results: ?368,000 (-8%)
Pound cost averaging results: ?380,000 (-5%)
By phasing investment over a period of time, you can reduce the risk of markets falling after you invest (although it does come at the cost to the gain you could have made should markets move upwards). In scenario 3 Pound Cost Averaging reduced the first year loss by 37.5%.
This is a principal of phasing money into equities and other investment assets. You can choose your time frames, eg, whether to invest every month and how long for.
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.
As always, you should seek professional advice for your personal circumstances from a company such as Blevins Franks.
By Bill Blevins, Managing Director, Blevins Franks
29th March 2011