It would be fair to say that the South African equity and bond markets have been a little problematic over the past few months.
The equity market has declined by nearly seven percent since its March peak. If you were invested in bonds, you've taken a knock of about four percent since February. Not even an interest rate cut managed to fuel a decent rally. Just when we thought it was safe to invest in the markets...
I find it ironic that so many times when cash appears to yield the lowest return and other assets seem so much more exciting, cash's ability to hold its value comes to the fore as an attraction for investors.
Numerous studies have been conducted on the concept of rand-averaging versus lump- sum investing, and the subject can spark a heated debate. In this column, I will try to make some sense of the benefits of both investment approaches.
Lump-sum approach
Lump-sum investing is when an investor applies all or most of the funds available for investment in one go. In other words, if you are buying a unit trust, you place all the money in the fund at one time. If you are buying shares, you place all of your orders around the same time so that the entire investment takes place at once.
The major benefits of lump-sum investing are simplicity, cost and, in the right market, maximum return. You have all your money in the market and you start monitoring the performance of your investment at the same time.
If the market moves above the level at which you invested, you maximise the return on your investment by having taken advantage of the low point to invest. In addition, if you invest a substantial amount, you may be able to negotiate lower transaction fees. In the case of brokerage fees, when dealing in individual shares it certainly pays to deal in bigger amounts at any one time.
Investors who are in favour of lump-sum investing are firm believers that time in the market is better than trying to time the market. Lump-sum investing only gives you one shot at getting your timing right.
The biggest risk of this approach is that you invest all of your money at a high point in the market, and end up waiting a long time to show any gains on your investment.
For example, if you invested a lump sum at the high points of the local equity market in 1969, 1974, 1980, 1987, 1998 and 2002, you had to wait at least two years before your investment was worth what you put in. These high points were usually preceded by long periods of rising markets. In other words, the high points were followed by pull-backs or declines in the market. However, in the long run (since 1960), the South African equity market has grown at an average of about 15 percent a year, so ultimately you would have benefited from being invested despite getting the shorter-term timing wrong.
Rand-averaging approach
Rand-averaging is when an investor splits the investment over a period of time - for example, investing one-twelfth of the money available each month, over a year. If you are investing in unit trusts, you may have a debit order investment and if you are investing in shares, you may place a few orders each month until you are fully invested.
The main advantage of rand- averaging is that it gives you a few opportunities to enter the market at a good level. In other words, if the market is lower at any point after you made your first investment, you get an opportunity to buy some of the same investments at a lower price. One way to think about this is holding back some spending in case there is a markdown on items of which you want to buy more.
Costs can negate any advantage you may derive by investing at lower prices, as brokerage costs in particular can be very high on smaller amounts.
The major disadvantage of rand-averaging is the risk that the market never drops below the level at which you started investing. This means you paid more for your investment than you needed to.
Which is best?
The right investment approach largely depends on the behaviour of the equity market.
In a market that is trending strongly upwards, you want to run with the market and make a lump-sum investment.
You should also feel more confident to invest a lump sum after the market has performed poorly, which is, of course, the time you feel least convinced to do so.
In a more volatile market that moves sideways or even declines, you are better off staggering your investment using the rand-averaging approach.
So what to do now? We cannot see into the future, but one pointer we have as to the future trend of the market is to look at recent performance and to try to assess the most likely behaviour in future.
We have seen good returns from the South African equity market for two years now. Bull markets tend to last longer than that, and many of the major long-term indicators for our equity market remain positive (for example, a stable currency, lower interest rates and good domestic growth).
However, it is not uncommon for even the best of the bulls to take a breather at some point. Currently, I would slow down to a stagger as far as committing money to the equity market is concerned and spread new investments over a period of time.