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Following on from us covering the difference between Saving vs Investing and with so much reported on the recent market movements, it would be important to highlight why and what the impact is of investing at the right time. Also what the true effect is of continuing to use purchasing power over time to ultimately add value to your portfolio.

While much information circulates in our community regarding the impetus to buy good value stock, equity or units in funds, there is one classical item which could use attention with respect to the value of buying during corrective periods. That item is the power of Dollar Cost Averaging over time.

When you create and review a set of dollar cost averaging numbers, it becomes apparent that during these periods of severe price decline or correction, accompanied mental exhaustion, great wealth is made.

Illustrated below are two hypothetical price performance periods using gold as an example:

 

dollar cost averaging

 

Gold Scenario A: depicts a 12-month period of increasing gold prices compounded at a 2% rate, producing a total of a 24% “bull run”. Gold Scenario B: depicts an extremely painful 30%+ correction and subsequent recovery to starting-point levels over a 12-month period.

At first glance, you might assume an investor gained 24% under Scenario A and nothing under Scenario B except for potential losses and grey hair. A closer look at a set of dollar cost averaging data however, tells a wildly different story.

Let’s assume an investor has the courage to create and execute a $1,000 a month investment program towards buying units. In applying that program to the two scenarios laid out above, a fascinating result begins to emerge:

 

dollar cost averaging

 

As the numbers demonstrate, Scenario A’s 24% “bull run” produced a pitiful return on capital, and as a headline figure was very misleading. A disciplined investor allocating $1,000 a month under this scenario, saw a total real gain of only 12% at the end of the twelve month period.

Under Scenario B however, our disciplined investor’s $1,000 a month investment program produced a total real gain of 28% on his or her capital, in what could be described as a “sideways” (or unprofitable) unit price environment.

What’s also interesting to note, is that not only did Scenario B produce a far greater gain, but it does so at a (counter-intuitively) much lower risk.

To illustrate, let’s assume that at the end of the 12-month period Scenario A suffers a “minor dip” in price, returning to its initial starting level at $1,000 per unit. Let’s also assume Scenario B jumps by 24%, effectively switching places price-wise with Scenario A. Here is a chart of that price swap:

 

dollar cost averaging

 

As mentioned, while this price swap appears to be just a “minor dip and corresponding jump”, as the numbers will indicate, the risk of financial loss in Scenario A becomes staggering, while the upside gains under Scenario B become equally explosive:

 

dollar cost averaging

 

As demonstrated, a correction to starting point in Scenario A produces a real total loss of 10%. A price swap in Scenario B on the other hand (i.e. a move from $1,000 per unit to $1,243 per unit), produces a 59% total gain. Therefore, the disciplined investor who continued to allocate $1,000 a month in the face of a frightening 30% collapse, was rewarded tremendously.

The moral of the story here is to continue to add fresh capital to your investments during declines. And it doesn’t have to be in just one Fund you can utilise those Funds surrounding Commodities, Healthcare, Technology or Shares of Companies.

Additionally, when struggling through the corrective depths of any asset’s “Scenario B”, it’s important to ensure that whatever you’re accumulating has real (and strengthening) fundamental value. Therefore, the longer the corrective period persists the greater will be your ultimate upside in the subsequent recovery. In other words, with strengthening fundamentals time is labouring for you rather than against you.

Bottom Line: The discipline of incremental investment over time may position one for explosive upside gains and reduced downside risk. Ensure that whatever is being accumulated however, is fairly priced, and of increasing fundamental value.

savings vs investing

One of the reasons many people decide to live and work in the UAE is the zero per cent income tax. If that’s your case, the incentive might be an excellent opportunity for you to save more money. After all, you don’t have to pay out a large chunk of your salary each month in income tax.

Being able to save more money is great, because you want to ensure that money is there when you need it, not just for now but later in life. Whether it is for a comfortable retirement, your children’s education or a large asset purchase, you want to have money available.

Although this may be true, using a local or international bank to build up cash deposits won’t help your savings. The reason for this is simple. There is often zero or very little growth to this cash resulting in erosion due to real-time inflation. At the end of the day, your money is losing purchasing power while sitting in a bank savings account. Another key point to consider is the nature of a savings account. The money is always readily available to you. So you might end up using this cash to buy that extra pair of shoes, a night out or any other unnecessary purchase.

There’s a Better Way to Save

An anonymous source once said, “If you never save money or invest, you will always be poor, no matter how much you earn.” That’s a fact! We all know that if you always spend everything you earn you will never have money.

As mentioned before, saving money is great. You should keep it up but in a more structured way. A way that gives you the medium to long-term growth opportunity while maintaining an element of access in times of difficulty.

Did you know that if you save your money rather than investing it, you will probably have to put away a lot more for a lot longer to achieve the same result?

Let’s take a look at the case study of ‘John Saver’ and ‘Daniel investor’ as an example.

John Saver vs Daniel Investor: A Case Study

Both men are the same age, working for the same company and earning the same income. They both have no debt, and very little in terms of assets. However, they are at a point where they understand the importance of putting aside money for their future. They feel that they need to save $1 million by the age of 60 to be able to retire comfortably.

John Saver:                                                                                                     

  • Age: 40
  • Annual Salary: $100,000 USD ($8,333 pm)
  • Current Savings: $100,000 USD
  • Savings Goal by 60 (Retirement): $1,000,000
  • Required Monthly Contribution: $3,750

John is already 50% through his working life but has only managed to save one tenth of the amount he needs to retire. To get to the desired $1 million, he needs to put away $3,750 per month into his bank account for 20 years.

The problem is that John has always been a bit of a spender. It might be very ambitious and quite challenging to change that suddenly and put away almost 50% of his salary towards savings.

As a result, John often fails to either set aside the total amount or dips into his savings as unexpected costs arise.

Daniel Investor:

  • Age :40
  • Annual Salary : $100,000 USD ($8,333 pm)
  • Current Investment: $100,000 USD
  • Investment Goal by 60 (Retirement): $1,000,000
  • Required Monthly Contribution: $2,000

Daniel is also in a similar position. He is already 50% through his working life and has only managed to save one tenth of the amount he needs to retire. However, Daniel decided to set up a savings account aimed at investing regularly. To achieve his retirement goal of $1 million, he will have to contribute $2,000 per month.

This money is directly debited from his account the day after his salary is deposited as a disciplined action. Therefore, he doesn’t even have a chance to notice the money gone.

Daniel’s funds are then actively invested and managed. They are now benefiting from the wonderful wonders of compounding interest. This means he is taking full advantage of accumulating interest on top of accumulated interest for all the years he is investing.

Let’s put compounding interest into perspective. Daniel’s initial deposit of $2,000 will be worth $5,300 at the end of the 20-year term! At the same token, his first year’s contribution of $24,000 will be worth $63,700 by the end of the term*.

As a result, Daniel can continue leading the life he enjoys. He can keep the small luxuries and current lifestyle, knowing he is well on the way to achieve his retirement goals.

In fact with the additional spending money that he is left with every year, Daniel is planning on taking a three week holiday travelling around Europe later this year and will be on track with putting a down payment on an investment property this time next year.

If Daniel decided to contribute the same amount to his investment plan as his friend John, he would have a whopping additional $787,000 in his pension pot by the time he was ready to retire.

So ask yourself… Do you want to work smarter, or harder? Are you John or Daniel?

* This projection is based on illustration purposes. If you decide to set up any structured savings, the term should be determined by affordability and time scales in the UAE. A short-term plan may suit you better.

Reduce your portfolio risk

You no doubt have heard about the benefits of diversification, It’s not just “all talk”. Your portfolio must have some degree of diversification. After all, you don’t want to “put all your eggs in one basket”.

Investing all your money in one or a limited number of assets increases the risk of your portfolio. If something goes wrong with one of these assets, this could impact all your money. Rather than having all your eggs in one basket, you take some and put them in different baskets (asset classes). That’s diversification.

What is Diversification?

Diversification is the attempt to reduce exposure to risk by spreading your investment across carefully selected asset classes and geographical regions. You can achieve diversification by allocating, for instance, a certain percentage of your investment to fixed income, equities, real estate, alternative investments, in different sectors, industries or countries.

Although diversification is no guarantee against loss, it’s a prudent strategy you can adopt towards your long-term financial goals.

Why Diversification Work?

Many studies demonstrate the effectiveness of diversification. To put it simply, when you spread your investment across low correlation assets, you reduce the exposure to volatility. The reason for this is that different asset classes and geographical regions don’t move up and down simultaneously or at the same rate. So, if you mix things up in your portfolio, you’re less likely to experience major drops. Remember that some sectors might be thriving while others are going through tough times.

How to Diversify Your Portfolio?

Personal finance courses teach this concept widely in contrast to individual stocks investing. They consider single stock investing similar to casino gambling. In fact, many investors never even invest in individual stocks. Instead, they prefer mutual funds and exchange-traded funds (ETFs). These funds bundle hundreds of stock from various companies and sell them as a singular unit.

You can diversify your portfolio by selecting mutual funds and ETFs from different sectors that follow different trends. Some might follow the ups and downs of the broader market while others remain relatively flat. Other funds might move inversely to the broader market, experiencing ups when most sectors are down and vice versa. So no matter how the market is behaving, a portion of your portfolio is likely to do well. At the same time, this strategy protects against the full exposure of a correction.

Generally speaking, a well-balanced portfolio diversifies away the maximum amount of market risk. Owning additional asset classes takes away the potential of big gainers significantly impacting your bottom line. This is the case with large mutual funds investing in hundreds of stocks, in theory, putting your eggs in hundreds of different baskets.