This article was published on 7 April 2012. Some information may be out of date.

Slow and steady not always the way to win

Slow and steady isn’t always best when it comes to regular investing. We’ll look at making annual investments, to keep it simple. But the same principle applies to contributing to KiwiSaver or other investments in which you make more frequent deposits of the same amount.

Let’s say you deposit $1000 at the start of each year for ten years. Would you prefer to invest in Ultrasmooth Fund, whose unit price is $4 for three years, $5 for the next four years and then $6 for the last three years, or Wobbly Fund, whose price is as follows: $4, $3, $7, $6, $1, $2, $9, $7, $5, $6?

Both started at $4 and ended at $6, with an average unit price of $5. And we’ll assume their taxes and fees are the same.

I suspect many people would prefer Ultrasmooth’s steady rise. But they would end up with considerably less money.

The arithmetic for Ultrasmooth is simple. At $4, you bought 250 units each year for three years, giving you a total of 750 units. At $5, you bought 200 units for four years, giving you 800 units. And at $6 you bought 166.67 units for three years, giving you 500 units. You ended up with 2050 units. At the end price of $6, that comes to $12,300.

For Wobbly, at $4 you got 250 units, at $3 you got 333 units and so on. Out with the calculator — or trust me that the total is 3013.5 units. At $6 each, that comes to $18,081 — almost 50 per cent more.

How did that happen? Your $1000 bought far more units when they were cheap than when they were expensive. At $1, you got 1000 units; at $9 you got just 111. So while the average market price was $5, the average price you paid was way lower.

This is sometimes called dollar cost averaging. It applies if two things are going on:

  • You invest the same or much the same amount regularly.
  • The price of the investment changes over time.

And the more the price changes, the more you gain from dollar cost averaging.

I should acknowledge here that my examples are extreme. Probably no fund is as smooth or as wobbly as these two. But using these numbers makes the point clear.

Even with much subtler differences in volatility, regular investors will tend to do better over the long term if they put their money into more volatile investments.

Note, too, that Ultrasmooth and Wobbly had the same average unit price over the period.

In reality, though, Ultrasmooth would have invested largely in high-quality short-term deposits to get such a smooth ride. Meanwhile, Wobbly would have been in shares and property. And usually, over ten years, these riskier assets bring higher returns — so Wobbly’s final unit price would probably have been higher than Ultrasmooth’s.

So we have two effects — dollar cost averaging and higher average returns — both making it more likely that more volatile funds will grow faster. Examples of such funds are KiwiSaver growth funds or aggressive funds.

True, investing in a volatile fund might make you uncomfortable when its value drops a long way, which will — not might — happen sometimes.

But as long as you have at least 10 or 12 years — and preferably 20 or more — before you withdraw your money, things should turn out fine. Funds that are diversified — which means they hold lots of different assets — always come back up again in the end.

And keep in mind during a downturn that the new money you are putting in will buy more.

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.