15 December 2021
By Colin Lewis, Head of Strategic Advice, Fitzpatricks Private Wealth
We live in turbulent times with volatility on global share markets being the new norm due to China, the Fed, inflation pressure and the new Omicron COVID-19 variant etc. There’s always some reason for it. And when investment markets are volatile, logic can go out the window.
For many Australians, superannuation is their second largest ‘asset’ – after the family home. However, it’s important to recognise that super is an investment vehicle – not an asset class. Regardless of whether you invest via a super fund or personally outside super, it’s what you invest in – cash, shares, property etc. – that determines whether your wealth goes up or down. Super does not lose you money!
During periods of market instability, you may feel that super is no longer your best option and stop or reduce making voluntary contributions. But we know it’s an investment for the long-term and short-term volatility can be a good time to top-up your super. After all, you’re buying assets that are now cheaper and unless you’re about to retire, you have years – many years – for the market to move back in your favour.
Volatility leads to anxiety and it’s easy for investors to rationalise the need to ‘wait and see’. Some wait for the bottom of the market. Others wait until ‘confidence’ returns before investing. Ironically, even when markets recover, many investors wait for the market to fall again in the hope of picking up bargains.
Unfortunately, these investment approaches are flawed as they can create ‘investor paralysis’ and delaying investing may mean missing out on the benefits of markets that inevitably recover.
Emotions must be managed to achieve long-term goals. One powerful way to do this is ‘dollar cost averaging’ – making regular deposits into an investment at regular intervals over time.
Importantly, this way of investing can reduce the risk of investing during times of market volatility. It also helps avoid the pitfalls of attempting to ‘time’ entry into markets. Dollar cost averaging overcomes ‘investor paralysis’ by giving you the opportunity to build your exposure to growth assets in a disciplined way.
Take Cheryl who invests $100,000 in a managed fund. This involves purchasing ‘units’ which represent the value of the fund’s underlying assets often comprising Australian and international shares.
If Cheryl invests all at once when the unit price is $1, she will get 100,000 units. The unit price then dives to 70 cents and her investment is only worth $70,000. The unit price gradually recovers to 80 then 90 cents and in period 5 is $1.10. Cheryl’s patience has been rewarded as her investment is worth $110,000.
Compare this with Beryl who is reluctant to invest because of market volatility but is prepared to gradually invest $100,000 equally over the same five periods.
Beryl’s initial $20,000 investment acquires 20,000 units. Her second $20,000 investment acquires 28,571.43 units at 70 cents. Her third $20,000 gets her 25,000 units. Fourth, 22,222.22 units and final $20,000 investment gets her 18,181.82 units at $1.10. Beryl ends up with 113,975.47 units in the managed fund and has a better outcome because her investment is worth $125,373.
By committing to regular investment amounts, Beryl overcame ‘investor paralysis’ and purchased the managed fund units at a lower average unit price of just under 88 cents.
That’s the essence of dollar cost averaging. When you commit to investing a fixed amount into an investment that varies in price, such as shares or managed fund units, you purchase more when the price is low and less when the price is higher. It should not be viewed as a guarantee of maximising returns, nor does it mean you should never invest a lump sum as part of a long-term financial strategy. Rather, it’s a way to potentially lower the costs of investing and a powerful risk reduction strategy for investors who would otherwise be reluctant to stick to a long-term investment plan in the face of volatility.
The good news is that dollar cost averaging is how most wage earners invest in super – via their employer’s regular compulsory super contributions. Similarly, most voluntary salary sacrifice contributions are made via regular contributions.
That’s why it’s important that investors don’t lose faith in this approach and reduce their contributions when markets are weak because in many ways that’s when dollar cost averaging works best.
Saving for retirement via super is an effective way to invest because there are significant tax benefits. When markets fall, you are better off being in superannuation than out of it as super actually protects you from market losses because these tax benefits have already insulated you from ‘loss’.
Take Roger who earns $150,000 a year and is on a tax rate of 39 per cent (including Medicare levy). By making pre-tax salary sacrifice or personal deductible contributions Roger puts 85 cents of each dollar to work in super as opposed to only 61 cents had he paid tax and invested outside super.
The tax benefits of super make it harder for Roger to lose money. The money he saves in tax means his super investments must drop 28 per cent before he is worse-off from continuing with his super strategy.
As most people aren’t fully invested in equities, a decline in markets needs to be even greater to be worse off – assuming other asset classes haven’t fallen simultaneously. If Roger had a 70 per cent exposure to equities in his super portfolio, the market needs to drop 40 per cent for him to be worse off.
For someone on the 34.5 per cent tax rate (including Medicare levy) and the same exposure to equities in super, the market must drop 33 per cent to be worse off. And someone on say $200,000 a year and the top tax rate, the market must drop 54 per cent.
The tax benefits of super and the risk-management, cost-cutting benefits of dollar cost averaging means that sticking with a disciplined contributions strategy is still compelling even when markets move against you.
*This information is prepared by Fitzpatricks Private Wealth Pty Ltd (Fitzpatricks) ABN 33 093 667 595 AFSL No. 247 429 and, where relevant, its related bodies corporate. The information in this publication is of a general nature only. All information has been prepared without taking into account your objectives, financial situation or needs. Because of this, we recommend you consider, with or without the assistance of a financial adviser, whether the information is appropriate for you.