Using tools to make better investment decisions

2018 has certainly been off to a volatile start. Stock markets are jittery, the Fed has just raised interest rates yet again and investors around the world are wondering whether the party is over.

The US stock market in particular is expensive, and even though many major markets around the world are relatively cheaper, any unexpected shocks in the US will have an impact that is felt around the globe:

Against this backdrop, investors who wish to commit new capital to the market are understandably uneasy regarding the best way to do so. Quite simply, the conundrum is as follows: invest a lump sum now and stand the risk of losing money if markets fall; or - you could 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 perspective is representative of the way many investors view the problem.

Will phasing-in your investment help to mitigate risk?

Many investors will be asking the question as to whether new money should be phased-in to the market or not. Although there are some behavioural and psychological benefits to phasing, such as temporarily reducing volatility during the early part of the investment period, these benefits are exactly consistent at each point in time with your effective asset allocation mix between cash and that of your chosen investments. This is clearly an inconsistency with your strategy, i.e. somewhere along the way there is a mismatch between your actual exposure to risk and the required level of risk you need to take in order to meet your objectives – which may result in a shortfall when you eventually need to redeem the investment.

In other words, the luxury of being able to "sleep better at night" comes at the cost of you not being sufficiently exposed to risky assets to be able to meet your longer-term objectives.

Bear in mind that the reason you have chosen to accept exposure to risk assets in the first place is because you expect to achieve better inflation beating returns compared to what can be delivered from holding cash.

We recently undertook some research into testing the philosophy behind phasing-in your investments to better quantify the benefits or otherwise for investors: The chart below displays the summarised results of our research into the success rate of phasing-in an investment over various periods (specifically from cash into the SA equity market).

As can be seen, when measured over different market cycles and through a number of decades, the chances of being able to add value through phasing is only about 1 in 3. And although some investors may try to improve their odds by using a number of valuation indicators, in our experience thus far we have not been able to find a reliable metric that can predict market direction over such short periods. (As an aside, if you have in fact been able to find one please do let us know!).

So ultimately one has to weigh-up the psychological benefits against the statistical evidence quite carefully before taking any action.

A debit order is not phasing-in

Be wary, however, of the mistake of confusing a phased-in approach with a debit order investment. A debit order is effectively a long series of lump sums, because shortly after you receive the cash inflow (via your salary, etc.) you then invest it. Hence you don’t need to be concerned that you are likely to detract value by starting a debit order versus waiting to save up a lump sum in your savings account (or under the mattress!) before actually investing. I cannot stress this enough. These are two completely different things.

Phasing is when you have a lump sum to invest, but purposefully and consciously hold a proportion of your funds in cash and then slowly release it into your chosen investment in a systematic manner. The reality is that while markets do fall drastically from time to time, history shows that on average the up months outnumber the down months by a factor of 2-1. Hence it generally helps to have as much exposure to your chosen investment as soon as possible.

Is investing all about the returns?

So how does one go about choosing the correct investment? Let’s consider the impact of your strategic asset allocation on your ability to achieve investment goals using a simplified decision-making process of choosing the appropriate asset allocation for your objectives.

If you were given a choice as to any of the following investments, which would you go for? All you know right now is that in ten years’ time you can expect to end up with the following rand amounts based on an initial investment of R10 000 today:

A rational investor (based on this very limited set of information) should choose option 7.

The benefit of stochastic simulation

We’ve done significant work in analysing decades of historical market data to develop a stochastic framework to project potential future returns. Stochastic simulation has an advantage over traditional deterministic methods because as we know, markets don’t go up (or down!) in a straight line. Although still not perfect, and where the quality of outputs are enormously dependent on the skills and experience of the team building the model, stochastic simulation allows us to understand higher dimensions of solutions to the question that all investors will ask at some point: "How much can I expect to have in x years’ time?"

The benefit of stochastics is not that you end up with a single, correct answer! In fact depending on the way in which the modelling is done, you may actually have hundreds, thousands or even millions of answers that could end up being right. Rather, along with using statistical techniques we have the ability to get a better understanding of the chosen investment’s expected future behaviour in aggregate, and this helps us to manage investor’s expectations far better than if we were just doing a simple deterministic projection:

The chart above now adds further dimensions for the investor. Not only do we have information on the future expected return, but the future expected range as well. It is worth mentioning at this point that each option happens to be an investment that provides expected real returns of 1% to 7% (consistent with the naming convention) where the asset allocation has been optimised on a forward-looking basis.

Now with this additional information, investors might perhaps consider that option 7 has too much variability around the expected value, which might make them uncomfortable. Therefore investors could rationally migrate down the risk spectrum to perhaps option 4 or 5, by reducing downside risk in exchange for lower expected returns. Remember that the period under consideration is 10 years, and the actual outcome will only be known at that point in time. And of course, the investor’s preferences could be very different if a different time period is used – whether it is 20 years or just 3 years.

The human mind is a pattern-seeking device, which is why we look for trends and base our judgements on what we believe will be long lasting outcomes – even though we often make the mistake of using very short time periods to develop these judgements. Even worse, once we’ve made up our mind, we are very stubborn to change it, sometimes despite overwhelming evidence contrary to our view.

So given our ingrained human biases a further piece of useful information that investors should know upfront is how these investments are expected to perform on a much shorter timeframe such as on a monthly or annual basis, because that is typically the period which investors tend to use when reacting to market movements:

The objective of optimising asset allocation is to minimise the impact of drawdowns on the client’s investment for a given level of expected return. Here we can see how investments with higher expected returns also tend to experience higher volatility over shorter periods as risky asset classes do have quite specific characteristics. Regardless of how one combines them to create a diversified portfolio it is pretty much impossible to completely diversify away the risk of short term capital volatility if you want inflation beating returns over time.

Conclusion

Don’t be afraid of market volatility. If you have chosen your mandates and managers correctly you should be just fine over the long term. As mentioned above, non-linear approaches to understanding investment behaviour are much better at managing expectations upfront by giving more insight into the investment’s potential future characteristics. 

Balancing risk and being wary of costs will certainly assist in ensuring that you are eventually successful in your endeavours. Partnering with financial planning experts who can assist you will be invaluable over the long term – there is really no need to have to go through the process alone.