A Sense for Money
If you had invested a million dollars in the stock market in 2008, your investment could have halved in value by the end of the year. On the other hand, if you had invested your million in the right stocks just after the crash, you could have doubled your money very quickly.
Stories like this abound. It is not uncommon for risky investments to double in value or to halve in value over quite a short time period. This makes investment in stocks look more like a lottery than a wise way to accumulate wealth.
This week’s post discusses how to tame the volatility beast and make it a friend rather than an enemy.
The ideal way is to get the timing right – buy low and sell high: buy just before the market booms and sell just before it crashes. The problem with this strategy is that nobody knows for sure when the market is going to boom or crash. Investment gurus often profess to know but they will often conflict and many get it right once only to be caught out at the next market swing.
Diversification is one very efficient way of reducing the volatility – we discussed this in a previous post. Volatility can be reduced by having a portfolio diversified by:
• asset class: equities, bonds, property, gold, insurance policies, etc.
• individual holdings: such as a good spread of equities rather than just picking one or two stocks.
• currency and market: exposure to more than one currency or country.
• manager: a selection of fund managers, banks or insurance companies to reduce the risks of underperformance or insolvency of any one.
The most reliable way of managing equity market volatility is through a technique known as dollar cost averaging.
The principle is simple: invest a fixed amount at regular intervals, irrespective of whether you feel the market is high or low. Investing a regular fixed amount ensures you buy more shares when the market is low and buy less shares when the market is high. This approach reduces the average price at which you buy the shares. So you are automatically getting the volatility to work to your benefit. If the market grows totally smoothly at 8 percent per annum, then your return will be 8 percent exactly, whenever you invest. On the other hand, if the market is highly volatile, but grows at an average of 8 percent, then the dollar cost averaging will normally increase your average return, often by several percent. The more volatile the market, the better the lift you get out of the dollar cost averaging. This strategy works for other types of volatile asset, such as gold, mutual funds, unit trusts etc.
Dollar cost averaging also helps in a falling market. If you invest a lump sum today and the market declines by 50 percent, then your entire lump sum devalues by 50 percent. Invest the lump sum in regular installments over a year or more, and your losses will be lower, since you will buy some of the shares at a lower price.
This approach also ensures you do not over invest when the market is high and under invest when it is low. This may seem like an easy thing to avoid but it is amazing how market euphoria takes over rational thought when markets are booming and people always seem to pour in money just before a crash.
Probably the major benefit of dollar cost averaging is discipline and commitment. Making a commitment to invest regular smaller amounts avoids the risk of investing just before a crash, avoids the temptation of spending the cash, and also avoids you falling into the temptation of trying to second guess the right time to invest.
A final technique to manage the volatility of your portfolio is to de-risk as you approach the time you wish to realize your investments. For example, if you plan to retire at age 60, you may invest entirely in risky assets until you are age 50 and gradually switch to low risk and liquid investments over the ten years before retirement. This means you can enjoy the benefits of the stock market throughout most of your accumulation period whilst avoiding your dreams being shattered by a market crash just before you retire.
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