Should you phase-in your investments?

Should you phase-in your investments?

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The new year has certainly been off to a volatile start. Stock markets around the world are in turmoil, the Fed has just raised interest rates for the first time in almost a decade and both commodities and the rand continue to test new lows.

Against this backdrop, many investors who wish to commit new capital to the market are understandably uneasy about the best way to do so. Putting it perhaps very simply, the conundrum is as follows: invest now and stand the risk of losing money over the near term or wait and be exposed to the risk that markets go up while you earn lower returns due to being invested in cash. This rather pessimistic view is nevertheless representative of the way many investors approach this problem, with a large proportion of investors deciding that to ‘phase-in’ their investments over three, six or 12 months is a good strategy to hedge against these risks.

We decided to test the optimality of this approach and arrived at some interesting conclusions. For our analysis we used a simple set of investment choices where one can either be invested in cash or the domestic equity market. Being well aware of the rise in popularity of multi-asset funds in recent years it is worth noting that similar results would be achieved when testing investments into a multi-asset fund.

Chart 1 shows that regardless of the period the investor may choose to phase-in their investments, the chances of outperforming a simple buy and hold strategy is only about one in three, as represented by the dotted orange line. We also noticed that the longer the phase-in period, the lower the chances of success tend to be. This can be explained by using chart 2 (below).

Chances of success for various phased-in strategies

Since January 1960, the South African equity market, when measured on a monthly basis, has gone up 63% of the time and beaten after-tax1 cash 59% of the time. Therefore, it makes sense to be exposed to the better performing asset class sooner and for as long as possible if you can tolerate the periodic drawdowns and volatility that are characteristic of equity investing. Chart 2 shows that the strategies with shorter phase-in periods achieved exactly this.

Effective equity exposure under various phase-in strategies

For example, the six-month phase-in achieved 67% equity exposure after just three months as compared to the 12-month strategy which only achieved 67% equity exposure after seven months. This four-month delay results in an opportunity cost for investors adopting the more conservative approach, on average – which is perfectly fine as long as the investor is aware of the potential outcomes of taking this course of action.

We also know that using averages can sometimes be misleading. So for the benefit of our readers we have included the unabridged results of our study for the 12-month phase-in strategy (see chart 3 below).

Frequency of value add/detraction for 12-month phase-in strategy

Having analysed 661 such 12-month periods since 1960, one can see from chart 3 that in 210 of these periods, the 12-month phase-in strategy added value compared to a simple ‘buy and hold’ (represented by the blocks to the right of the vertical orange line) while in the remaining 451 periods the phase-in detracted value.

It is also interesting to note that the two scenarios where the phase-in detracted the most value was during years in which the local equity market produced returns in excess of 100%. This occurred during the early 1980s, a period of very high volatility in local equity markets and when holding cash repeatedly alternated between being a drag on returns and a safe haven. Clearly, trying to time the market has not gotten any easier or predictable!

While there are indeed many ways to approach this problem and much depends on personal preferences, what matters most is that the investor chooses the appropriate fund(s) that will meet their particular long term investment goals. This is because regardless of the way you eventually choose to phase-in your investment, for the bulk of the time that you are invested you will be fully exposed to your chosen funds. This is true in all but the shortest of investment timeframes as shown in chart 4.

Proportion of total investment term that you will be fully exposed to your chosen funds

For example, if you plan to implement a six-month phase-in and your intention is to invest for five years altogether then 92% of the time your money will be fully exposed to your chosen funds. In this example, it is 11 times more important for your investment success that you choose the correct funds compared to the importance of choosing the correct phase-in strategy.

In summary, while phasing-in your investment can add value in some scenarios it is clear that investors should rather place more emphasis on finding investments that are consistent with their needs. Balancing risk and being wary of costs will certainly assist in ensuring that you are eventually successful. All of this should ideally be done in consultation with a professional financial advisor.

 

1 Based on a tax rate of 30%