Holm Truths Winter 2004

You’ve got four weeks’ holiday in the year, and your boss wants you to choose your holiday dates.

Should you take all four weeks at the start of the year? Or take the lot later, when you might need a long break more? Or would you get more out of it if you spread the breaks, with four one-week holidays throughout the year?

Similar options can arise with money.

Let’s say you’re lucky enough to receive a lump sum — perhaps an inheritance, redundancy payment, excess from moving to a cheaper house, a decision to move out of an investment, or even a lottery win. You face a series of decisions:

• Spend it or save it?
• If you save at least some of it, where do you invest?
• When do you invest?

We’ll assume that you save some or all of it, realising this is a big chance to get ahead.

We’ll also assume that you’ve decided to put the money into one or more of: shares, bonds, or a managed fund that invests in shares and/or property and/or bonds.

With all of these investments, values fluctuate. (The value of bonds fluctuates with interest rates. If rates rise to 7%, bonds paying 5% are worth less if you sell before maturity. But if rates fall to 3%, bonds paying 5% are attractive, and their price rises.)

Whenever values fluctuate, the timing of your investment will affect how well you do. So when should you make your move — now, later, or in instalments?

• Now has obvious merits. You’ve made your decision, so get on with it. The sooner you’re in the investment, the sooner you can make returns that, on average, should be better than leaving the money in the bank.

The trouble is that you never know when a market might suddenly fall. As people who invested in world shares around 2000 discovered, it’s really discouraging if your investment loses value before it has gained any ground.

Test yourself. Picture the value of your investment dropping by a quarter, or even half, in the first year or two. Would you hang in there, knowing that — as long as you’re diversified — it will almost certainly regain the losses and grow healthily over the long term? Or would you lose heart and bail out?

If you would do the latter, it’s not a good idea to invest all your money at once.

• Later can be justified only if you think prices will fall, or interest rates will rise. Such timing of markets is tricky stuff. Even the experts frequently get it wrong.

While you wait — quite likely earning less in a bank in the meantime — the markets might well turn against you rather than for you. Generally, trying to time markets is not a wise course.

The one possible exception is when a market has been going through an extraordinary growth period. Booms never last, and are quite often followed by rapid price falls.

So if you think an investment bubble is about to burst, you might stay on the sidelines for a while.

Note, though, that it’s extraordinarily difficult to pick the time a boom will end.

Let’s say the market index in your planned investment has grown rapidly from 1000 to 1500, and you decide to wait until it falls.

In the meantime, it might continue to grow to 2000, before falling to 1700. Despite the fall, you would have been better off getting in at 1500.

• With instalments, you can avoid the worries of bad timing.

Investing by instalment is particularly attractive during boom markets. But even when markets are stable, many people favour it.

You might invest a third of your money now, a third in three or six months, and a third in six or twelve months. If you’re dealing with a large sum, you might get fancier, and invest, say, 10% a month.

Just as diversifying over a wide range of investments lowers your risk, so does diversifying over a range of entry times.

It’s not advisable to stretch the process over more than a couple of years, though. Not only is the uninvested balance missing out on a probable higher return, but there’s also a psychological factor: Make your move and get on with life!

It’s a good idea, too, to be pretty disciplined about when you make the instalments.

To help with this, you might put the uninvested money into bank term deposits that mature at the times you want to invest.

THE DAY YOU BUY

For long-term investments, when you buy doesn’t make as much difference as you might think.

Let’s look at what would have happened if you had invested in the NZ share market during each of the last 30 years, ending December 2003.

In the first year you invested $600, but that amount grew by inflation over the period, so that in 2003 it was close to $5,000.

We’ll assume (because of the data we’ve got) that you always invested on the last day of a month — in other words, you had 12 days on which you could invest. We’ll also assume that you reinvested all dividends. No allowance is made for tax.

Scenario 1: You were extraordinarily lucky. Each year, you invested all your money on the day when share prices were at their lowest.

Over the 30 years, you would have accumulated $403,000.

Scenario 2: You were extraordinarily unlucky. Each year, you invested on the day when share prices were at their highest.

You would have accumulated $317,000. That’s not as big a difference as most people expect.

Scenario 3 You simply invested 1/12 of your money on each of the 12 days.

You would have accumulated $356,000 — a happy medium.

NOT SUCH A GOOD DEAL

Does dollar cost averaging apply when you invest a lump sum by instalment?

Firstly, what is dollar cost averaging? It occurs when you regularly put the same amount into an investment that fluctuates in value.

In a simple example, you invest $1,200 a month into a share fund.

For six months of the year, the units cost $12 each. So you get 100 units a month, or 600 units in six months.

In the other six months, units are only $8 each. You get 150 units a month, or 900 units in six months.

The average price over the year is $10, and you’ve bought a total of 1,500 units. You would expect, then, to have paid $15,000. In fact, though, $1,200 a month comes to only $14,400.

The saving comes because you bought more units when they were cheaper. And the more volatile the investment, the bigger the savings.

Dollar cost averaging works well for regular savers. But does it work when drip feeding a lump sum into an investment?

Yes. But there’s a downside.

You’ll be holding back some of the money, probably in a bank account, which will usually pay you a lower return than the investment.

In some cases, that will cancel out the gains from dollar cost averaging. It all depends on the volatility of the investment and the size of the difference in returns.

FROM THE MAILBOX

• The higher the interest paid, the higher the risk.
• If you take on risk, spread your money around.
• How easy is it to get your money out early?

Dear Mary:

I have about $35,000 that I have set aside to replace my car. I want to invest it in a reasonably accessible manner until that day arrives, which could be anything from next week to several years away. The obvious choice is a term deposit.

My first question is, how much risk to take to achieve a higher return than on a term deposit?

To date I have been favouring organisations that offer secured first ranked debentures, and have a G5 rating or better, and I look at terms of no longer than two years.

They generally are offering interest rates a good 2% better than the banks. Is this a reasonable low-ish risk strategy?

And is it worth chopping and changing organisations to get an extra 0.5% or 0.75% return?

For example, the money is about to mature with one company that is offering 7.25% for two years (easy to roll over), but another is offering 8%.

If I take the interest rates and cut off a third for tax (e.g. 8% becomes 5.36% net return), there is a $350 difference in the two returns over two years.

However, there is the hassle in having the money returned, filling out the new prospectus form, sending off the cheque etc. in order to change. Is it worth it and I’m just being lazy, or in the scheme of things does it not really matter?

Dear Reader:

Firstly, good on you for saving for your car. Too many people don’t, and then when their old car gives up and they need a new one in a hurry, they have to borrow.

It’s far better to be earning interest on your savings than to be paying interest on a car loan.

How much riskier is an outfit that offers higher interest than a bank? Certainly, somewhat.

Everybody, including finance companies, wants to get things as cheaply as possible.

A company that pays 7.25% is doing so only because it has to. It’s found that investors will take on the extra risk only if they are offered a premium above bank rates.

For the company that pays 8%, investors have decided the risk is higher.

This oversimplifies things a bit. The second company may not, in fact, be riskier, but may just want to raise more money faster. Generally speaking, though, the higher the return, the riskier the company paying it.

And several experts reckon that, in New Zealand, the premium above bank rates is often not enough to compensate for the extra risk. Too many investors just don’t understand risk levels.

So how can Joe and Joanne Blow tell just how risky these companies are? Not by looking for words like “secure”. As one expert says, “Secure just means that it’s a little safer than a promise of fresh air.”

The G5 rating you mention is from a free New Zealand service called Grosvenor BondWatch. On www.bondwatch.co.nz, it lists ratings for many finance company securities.

G1 is the safest. The highest number, G8, is “for sophisticated investors only.” A rating of G5 means “Adequate ability to meet current obligations, but uncertainty about levels of security over the longer term, particularly under adverse business conditions.”

The “longer term” is not defined. A two-year investment might be fairly safe, but maybe not.

Keep in mind, too, that Grosvenor uses only the information available in prospectuses and investment statements. Unlike international rating services Standard & Poors and Moodys, it doesn’t investigate beyond those documents. What if the company is lying?

Beyond that, some financial experts have criticised Grosvenor’s conclusions from the data it does use.

I still think the service has value. I would at least avoid any securities with a high BondWatch rating. But a low rating is no guarantee of safety. And G5 is only middling.

Having said all that, if you insist on riskier securities, at least spread your money over, say, five different companies. If one or two default, you could still buy a cheaper car.

The only trouble with spreading your money around is that it’s a bit of hassle, as you say. Perhaps you can be persuaded, though, by the risk reduction. Is a few hours now worth it, to avoid possible sleepless nights later?

One more point, and it’s an important one. You might need the money next week. With term deposits you can invest for short terms and keep rolling over. And you can always break a term deposit if you have to, although you will probably lose some interest.

Even with short-term debentures, there’s much less flexibility on when you can get at your money.

Life is short. I suggest you stick with term deposits, avoid the hassle, sleep well, and settle for one less feature on your new car.

LADDER TO SUCCESS

A good way to set up your fixed interest savings — in term deposits, government stock or bonds — is what is sometimes called laddering.

Say you’re investing for the long term, and you decide on five-year deposits or bonds because, in most market conditions, you can earn higher interest over five years than over shorter terms.

It’s best, however, to start out with varied terms, investing a fifth of the money for just one year, a fifth for two years, and so on, with the last fifth maturing after five years.

As each investment falls due, reinvest it for five more years, so it leapfrogs over the other four fifths.

There are two big advantages of laddering:

• You minimise interest rate risk. If there’s a period of higher-than-usual interest rates, at least some of your money will fall due at the right time and benefit from that.
• Liquidity. At any given time, some of your money will be less than a year away from its maturity date, should you unexpectedly need it in a hurry.

Mary Holm is a freelance journalist, a director of Financial Services Complaints Ltd (FSCL), a seminar presenter and a bestselling author on personal finance. From 2011 to 2019 she was a founding director of the Financial Markets Authority. Her opinions are personal, and do not reflect the position of any organisation in which she holds office. Mary’s advice is of a general nature, and she is not responsible for any loss that any reader may suffer from following it.