It is human nature to be cautious and look to avoid risk and danger. As our world becomes more sanitized, the kids of today take even less risk than their parents due to ever changing rules designed to protect them.
These rules come in all shapes and sizes whether it be seat belts and baby seats in cars, to knee pads and helmets when kids learn to cycle, or now face masks to prevent infection. Humans are therefore becoming more risk averse, and this has implications for us as we become adults.
As a financial coach I believe it is up to us in the financial industry to help clients understand what financial risk means, how it affects a client’s finances and ultimately to embrace appropriate levels of risk.
An example of appropriate risk is when you are young to start saving into higher risk or growth investments by dripping money into a fund on a monthly basis over a period of time. My Father sat me down with a financial advisor when I had completed my first year of work and strongly encouraged me to save a percentage of my salary.
At that time, I had no understanding of investing nor saving but ten years later, the fund provided me with the monies I had invested over the ten years plus a good profit so I could buy a property. During those ten years the markets saw significant volatility including a massive correction in 1987 in what became known as ‘Black Monday’.
My policy matured in 1994 when ‘Black Monday’ was already part of stock market history, and I slowly began to understand the logic of investing regularly. To help clients understand how they can benefit by investing regularly and embracing a sensible level of risk we have put together the below chart.
DOLLAR COST AVERAGING
Chart 1.1 depicts the performance of each portfolio in three different scenarios. Each scenario began at $10.00 per share.
First scenario: Investor invests $1,000 per year while the fund returns a steady growth of 4% per annum.
Second Scenario: Investor invests $1,000 per year while the performance of the fund is volatile which is the realistic market performance.
Third Scenario: Investor invests $10,000 at the start of year one and held until 10th year without making additional deposits or withdrawals.
| Dollar Cost Average | Total Contribution | Total Units Bought | Investment Value | Profit/(Loss) | Percentage | Fund Price (Year 1) | Fund Price (Year 2) |
Scenario 1 | 11.85 | $10,000.00 | 843.53 | $12,006.11 | $2,006.11 | 20% | $10.00 | $14.23 |
Scenario 2 | 9.17 | $10,000.00 | 1084.21 | $14,181.12 | $4,181.12 | 42% | $10.00 | $13.00 |
Scenario 3 | 10.00 | $10,000.00 | 1000.00 | $13,000.00 | $3,000.00 | 30% | $10.00 | $13.00 |
*Even though the share price in scenarios 2 and 3 ended in $13.00, which is less than the $14.00 price in scenario 1, both earned more than scenario 1. Scenario 2 earns the most because it purchased more units during market downturns than lumpsum investment in Scenario 3.
Chart 1.1, and the concept of ‘Dollar Cost Averaging’ is I believe very important for investors to grasp and as a coach, I put significant emphasis on explaining this to clients. The reality is that as a financial coach, it is up to us to make sure we get clients to get their full potential from their money by helping them to take the right amount of risk.
Key Points on Dollar Cost Averaging:
Dollar Cost Averaging is best when riding market volatility.
It reduces risks as it avoids investing all before a market crash.
This strategy can ride during market downturns.
The longer the bear market the more units you could bag.
This is good for long-term investing.
Often clients don’t understand the difference a few extra percent growth can make on their money which is why the job of the coach/advisor is so important so clients can achieve the best results. To explain the difference between risk and return we have put down a graph below which clearly shows the extra return a client can generate by adding a little risk.
RISK AND RETURN GRAPH
Chart 1.2 shows the possible returns of each investment depending on the level of their risk.
Bank deposits are considered low-risk investments because they provide a fixed return and are insured by the government.
Government bonds also provide a higher fixed return than bank deposits. Because the issuer, in this case the government, promises to repay the principal, this is a less risky investment than stocks. However, there are risks of default, particularly during political or economic crises, making it riskier than bank deposits.
Stock markets are high risk because their performance is heavily influenced by company performance as well as broad market conditions. Stockholders, unlike bank deposits and bonds, have no idea how much money they will receive because of volatility. However, stocks can provide the highest returns if the company performs well, as stockholders can profit from capital appreciation or dividends.
RISK VS. RETURN TABLE
| Low Risk Bank Deposit (1% per annum) | Medium Risk Government Bonds (3% per annum) | High Risk S&P500 (10.70% per annum)* |
Year 0 | $10,000.00 | $10,000.00 | $10,000.00 |
Year 1 | $10,000.00 | $10,300.00 | $11,070.00 |
Year 5 | $10,510.10 | $11,592.74 | $16,624.10 |
Year 10 | $11,046.22 | $13,439.16 | $27,636.07 |
Year 20 | $12,201.90 | $18,061.11 | $76,375.21 |
To protect your portfolio in a variety of market environments, a proper combination of these various assets is required. An active approach is required to capitalize on gains while limiting risk. This is why our Investment Team in Astra always actively manages our clients' portfolios.
For the majority of us who invest monthly to save for goals like retirement, buying a property, school fees, wedding or other major investments the current volatility in the market is probably unlikely to be a significant factor. The volatility becomes a factor when your accumulated savings become a significant amount and you will need that money in the near future.
This is where a ‘financial coach’ or advisor can help you make sure that if you are soon to realize a significant part of your investment then it is very likely you will need to adjust your investment.
Your ‘financial coach’ can help by asking you questions about your plans for how and when you intend to spend the money and in what currency. Once you and your coach understand what you are trying to achieve, if necessary, your investments can be reallocated to reduce risk and preserve capital.
Typically, during the ‘growth years’ of your investment when you don’t require access to the funds the money will be invested into Equities, Funds, Real Estate and other growth-oriented investments which carry a reasonably high level of risk and volatility. As you approach the time when you will need access to your investment a good coach may recommend a phased movement of your investment from growth to cautious.
Cautious investments will include things like money market funds, government bonds, and maybe income producing assets like REITS. Your coach should also make sure that your investments are held in the currency you will require when you need the money to further reduce risk.
Summary:
During times of heightened volatility and turmoil which we are currently experiencing, it is more important than ever to work with a ‘financial coach’ to make sure your investments are appropriately positioned to match your needs. Often, we don’t think about these things and when the news is bad, and it is easy to just want to ignore everything and hope for the best. It is these times when a good coach can reassure you and make any changes necessary to protect your investment and give you peace of mind.
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