Advising clients how and where to invest their savings and superannuation funds is not an easy task to say the least. The economic climate over the last two years brought much volatility and turmoil within equity markets. As global markets behaved erratically the one question I was consistently being asked by my clients was, “Should I remain in cash or have a higher exposure to cash until the volatility subsides?” This was the million dollar question!
Throughout 2011 and 2012 it was evident that cash and term deposits were an attractive place to invest funds. Investors found it re-assuring to have their capital protected via term deposits compared to equities where there was daily exposure to market movements and volatility.
Cash and term deposits are great short term investments. But these asset classes are exactly just that; short term. You have a known return and your capital is quite secure. The reason many investors turn to term deposits is because it is an asset class commonly recognised as a stable low risk investment option, making it a far more attractive proposition for investors seeking a safe haven when there is euphoria surrounding equity markets.
The issue with cash over the long term though, is that its purchasing power becomes less attractive in an economic environment where the price of goods and services is growing exponentially. This all leads us back to two fundamental investment principles; “risk vs return” and “stage of life”.
Despite cash being a “safe haven”, long term investment has never been more important than in the current financial turmoil we have and are enduring. “Short term volatility can be thought of as an investor’s trade off for higher long term returns.”
A picture tells a thousand words so let’s look at the following graph:
The chart illustrates the total returns from Australian cash, Australian Bonds and Australian shares from 1900. A $1 investment in Australian shares in 1900 would have risen to $287,087 by December 2011 with a compound return of 11.9 per cent. By contrast the compound returns of 4.6% p.a and 6% p.a for cash and bonds would have seen $1 invested in these assets rise to only a fraction of this.
Historical data definitely points to the fact that investing directly into Australia Equities will inevitably result in a higher return than rather simply investing in term deposits or cash over the long term. We understand that investor behaviour can be tested in these volatile periods but over the long term we believe that exposure to both asset classes, i.e shares and cash, will provide the best protection to maintain your purchasing power and income needs.
It is therefore important to attempt to always apply the seven golden rules of investing in such times:
1. When markets are volatile, be patient
Reading the business section of the paper every day can give palpitations to even the hardiest investor. To retain your self-control, remember that emotive headlines are designed to sell papers not present clear, cold facts. While it is important to stay informed, a longer-term overview would be a better guide to investment performance.
2. Avoid crowds
All too often people delay investing in the share market until they are reassured by a long period of rising prices as more and more people invest. Unfortunately by then, much of the gain has been achieved and the shares have become expensive and vulnerable to downward adjustments.
So, avoid crowds by becoming a contrarian. Rather than follow the masses, seek advice. If an investment passes all the fundamental quality tests, invest before the price is driven up when the rest catch on.
3. DIVERSIFY
Selecting investments from different asset classes and sectors, across different geographical locations and from different companies, will help smooth returns by allowing the out performance of certain investments to compensate for the under performance of other investments. Diversification, therefore, lowers the risk of capital loss while helping an investment portfolio to grow over time.
4. Don’t be dazzled
by returns
It’s easy to be impressed by high returns but today’s return is only one of many selection criteria that should be used to choose an investment. The following questions provide a starting point: Does the investment have the potential to achieve your goals? Are you comfortable with the amount of risk associated with the investment? Is the investment a quality investment managed by an experienced and capable team?
5. Invest regularly
A disciplined savings plan that automatically invests regular amounts of money into the market, regardless of the investment climate, is a great way to start building wealth. This strategy called ‘dollar cost averaging’, works effectively because it operates independently of sentiment and is unaffected by investor exuberance or despair.
6. Consider tax implications
While making a profit on your investments is important, your after-tax position is even more important. It is wise to use investments that predominately achieve capital gains in preference to income, thereby incurring tax only when an investment is sold.
7. Maintain strategic asset allocation
When share markets are very volatile, the temptation is to put more funds into cash. Likewise, when share markets are rising, and cash rates are low, we look to ‘chase’ higher yields or returns from shares. One of the biggest challenges for investors is to maintain the discipline of adhering to their long term strategic asset allocation, based on their risk profile.
All representations and information contained in this article are made in good faith and are believed to be correct at time of preparation. This article is of a general nature and does not purport to be specific investment advice. Individual needs or other considerations have not been taken into account, thus information contained herein should not be relied upon as a substitute for detailed advice.
*Nick Davos is an Associate Director of Moneywise Personal Financial Management. You can email Nick on ndavos@moneywise.com.au with any queries or contact him on (03) 96497611.