Monthly Investment Plan

Stock markets have turned choppy after exceptional gains in 2009 and 2010. It is not hard to see why. The global economy seems to be sputtering. In the US, households are still deleveraging following the bursting of the property bubble. Japan is back in recession after its disasters. Asia and emerging economies are being threatened by rising inflation. Europe’s debt problems, meanwhile, remain deeply entrenched. In all cases, it is the public sector that is being challenged, either to rein in or support growth.

No wonder then that market sentiment has been volatile.

So what should you do when stock markets hit a speed bump? Some investors become fearful and take their money out. Others wait on the sidelines until the outlook becomes clearer. Why put in money or stay invested when stock prices could fall further, you may ask?

But it is the nature of markets to move up and down over the short term. Trying to predict their movement is hard, if not impossible. And markets often do the opposite of what you think they should. So your best bet is to stay the course, even during periods of volatility.

Research suggests that a systematic investment approach is often more profitable than one in which human judgement is allowed to play a role. Which is where the MIP (Monthly Investment Plan) comes in.

By feeding money into the market at monthly intervals the MIP allows one to build positions gradually. If markets stay soft, well, the more your money will buy at any given time; and if they go up, then your purchasing power goes down but the overall value of your portfolio increases.

The great thing about an MIP is the control it offers. You fix the amount you want to invest; you decide where you want to invest; and you can stop and re-start the plan at any time. It’s not a magic solution but it can help you avoid a lot of the common investment mistakes. Now read on…!

Broadly speaking, there are two types of investing: systematic and non-systematic. The first is a methodical approach and does not rely on one’s emotions or gut feelings. You put a fixed amount into the fund every month, regardless of market behaviour and the price of units. If the price of the fund goes down, you buy more units; if it goes up, you buy fewer units.

This approach is called ‘dollar cost averaging’. Simply it means that your average unit cost will be less than if you made an equivalent lump sum investment at its unit cost. Put another way, as prices fluctuate, you get more units.

The statistical effect becomes more obvious over time, especially in volatile markets, as the illustration below shows.

When emotion rules

Each year Dalbar, Inc. publishes an analysis of the effect on performance of investors’ buying and selling of US mutual funds. Although the numbers vary from year to year the message remains the same: the average investor earns significantly less than mutual fund performance would suggest.

Why is this? The answer lies in market timing. We all flatter ourselves that we can spot the right moment to enter or exit the market. In practice luck, mostly bad, plays as much a part as skill. Indeed, while the age-old advice to buy low and sell high is simple and obvious, our very unsystematic behaviour leads many of us to do the opposite.

Dalbar shows that over the 20 years ended 31 December 2007, the average equity fund investor would have earned an annualised return of just 4.5%, underperforming the S&P 500 by more than seven percentage points per year! Furthermore, $10,000 invested in equity funds in proportion to actual flows would have earned just $14,011, compared to $21,036 from a systematic approach that spread the $10,000 investment evenly over the 240 months (see chart). So your best course of action is to invest regularly and stay invested.

MIPs have become popular as a means of meeting pre-determined long-term needs.

Before you make any investment, it is always worth asking what your objectives are and whether they are suitable. A financial adviser can help. Or, you may like to go through a checklist when considering the suitability of your investment plans.

A good investment plan should consider both the external and internal aspects of investing, ie the different types of investment that are available and your attitude to risk. The biggest problem nearly every investor encounters is a mismatch between his return expectations and risk tolerance.

Risk and return are generally correlated, and the longer you hold an investment the more apparent this should become. Broadly speaking, equity funds are more volatile than bond funds, and single country funds more volatile than regional or global funds. Money market funds are safer than either, but they aim only for cash-plus returns.

With an MIP there is an argument for weighting your MIP more to higher risk asset classes because of the smoothing effect of dollar cost averaging, with your investments going into the market over time. That does not mean however that you should confine your investments to only one or two funds. There is nothing to prevent you from spreading your MIP across several funds; indeed, this may be sensible risk diversification.

Because of their systematic nature, MIPs have become popular as a means of planning for specific events, like retirement or your children’s school fees. In fact MIPs may be appropriate for any kind of long-term contingency; other examples could include medical or parent care expenses.

The take-up of MIPs varies across Asia. In Korea millions of workers have instalment plans which make up significant net flows into the stock market. In Australia, Malaysia and latterly Hong Kong, which have payroll-deducted pension schemes, contributions in effect behave like MIPs; whether self-selected or managed by a third party, they get funnelled into the market on a regular basis.

Even if you do make payments into a pension scheme, the case for investing in an MIP still stands. For unlike the west, where the welfare state is well-established, Asia does not have deep coverage hence savings rates tend to be higher. But these are not always well used. An MIP helps nudge you in the direction of growing those savings in an affordable way.

A CHECKLIST

What should you consider when investing? Some internal aspects to cover when establishing an investment plan:

• What are your investment goals and needs?
• How old are you?
• How strong is your financial position?
• How high is your tolerance for short-term volatility?
• To what extent do you need to be able to convert your investments into cash at any time?
• When will you need the money you have invested?
• How much diversification should you seek?
• What sort of investment style are you looking for?

You may have heard “cash is king”, an expression that refers to the fact that you’ll never lose money by holding cash.

But with deposit rates still low, you’re hardly getting good returns for sitting on cash. In fact, after taking account of inflation, returns are probably negative.

At the same time, market uncertainty has meant that so-called risky assets such as corporate bonds and equities offer attractive yields – much more attractive than the yield on cash deposits.

True, the price of risky assets can fall in the short term, and if companies cut their dividends the yield on their shares will not be as high as expected. But over the longer term holding such risky assets may be more rewarding than cash in the bank.