Rand Cost Averaging and our behavioural biases
The chart below highlights the importance of staying invested, and how time in the market compounds your initial investment. Market returns are heteroskedastic in that their volatility changes over time, and volatility clusters - meaning extreme movements are often followed by more extreme movements. While this can be stressful, it also means that during periods with extreme negative moves, you are also more likely to see extreme positive moves - so, selling out of equity markets to 'cap your losses' can not only crystallise losses, making them more difficult to recover, but it also reduces your exposure to potential shorter-term market recovery. This is further illustrated in the graph below where missing the best five days in the market over the ~21-year period would have reduced the value of your investment by almost a third.
Understanding the biases we are subject to is really valuable as investors, because it allows us to use objective data to formulate strategies that work to overcome them and serve us best over the long term.
Behavioural finance, the study of how our psychology influences our financial decision making, shows that we are subject to a number of these biases, some of which are:
Rand Cost Averaging (RCA) is a strategy where investors phase in an investment on a regular schedule or over regular intervals, regardless of the most recent performance, as opposed to a once-off lump sum investment. In doing so investors can capture different prices over time, thereby smoothing out the risk of price volatility. This strategy can help us overcome these biases, ensuring two valuable investment traits: diligence and patience.
The chart below illustrates the strategy, assuming the investor buys into FNB Growth on the last day of every month over the last year. Using RCA keeps the investor buying into the unit trust despite the decline between March and June 2022, 'averaging down' their investment cost. However, since forecasting performance over short periods is a fraught affair, we keep phasing the investment in while the price is rising. As mentioned above, RCA is most useful for reducing volatility in the early stages of an investment when market moves can most impact the value of your funds.
For example, we look at all 90-day investment outcomes from investing in FNB Growth. While two thirds of the time investments have grown by 0-10% in 90 days, in 27% of the time investments have declined by up to 10% over this short period. As highlighted earlier, that can be stressful. However, it is important to keep a long-term perspective, and in the RCA strategy, rather than all your funds being invested 90 days prior and suffering these short-term losses, you have the diligence to continue phasing your investment in, now buying the same investment at cheaper prices.
Let's compare the two strategies over a longer period of five years, looking at the performance of FNB Growth. The RCA strategy involves investing R1 000 per month x 60 months, giving a balance on 31 March 2023 of R75,982. While the fund would have outperformed this strategy over five years (more time in the market means more time for investments to grow, and compound), this would have required a lump sum investment of R52,264 in 2018, and along the way it would have resulted in some significant short-term losses, like during the Covid-19-induced market crash of 2020.
Is RCA a suitable strategy to avoiding these losses as much as possible? The graph below shows the maximum drawdowns1 of the lump sum and RCA strategies. While a lump sum investment is sensitive to entry price, a RCA strategy can result in less sensitive drawdown profiles. Because the investment account is regularly being topped up, with the 'entry price' being averaged down during period of drawdowns, the investor can experience smaller drawdowns - and less time in the red.
A maximum drawdown (MDD) measures the largest observed loss - measured from the highest value reached (peak) to the lowest point reached (trough), before a new peak.
Not only is your journey as an investor smoother, particularly over the early years of your investment, but using this strategy sets you up to form good financial habits. Investing is a long-term game, and for you to get the most benefit over the long term, it requires you to start early and invest regularly.
FNB CIS Manco (RF) (Pty) Ltd (Registration Number 2006/036970/07) ('FNB CIS Manco') is an approved Collective Investment Schemes Manager in terms of the Collective Investment Schemes Control Act, No. 45 of 2002. The FNB CIS Manco is regulated by the Financial Sector Conduct Authority("the Authority) and is a full member of the Association for Savings and Investment South Africa ('ASISA'). This document and any other information supplied in connection with the FNB CIS Manco is not 'advice' as defined and/or contemplated in terms of the Financial Advisory and Intermediary Services Act, 37 of 2002 ('the FAIS Act') and investors are encouraged to obtain their own independent advice prior to buying participatory interests in the collective investments scheme ('CIS') portfolios issued under the FNB CIS Manco. Any investment is speculative and involves significant risks and therefore, prior to investing, investors should fully understand the portfolios and any risks associated with them. Collective Investment schemes in Securities are generally medium to long term investments. If a potential investor requires material risks disclosures for the foreign securities included in a portfolio, the manager will upon request provide such potential investor with a document outlining: potential constraints on liquidity and repatriation of funds; macroeconomic risk; political risk; foreign exchange risk; tax risk; settlement risk; and potential limitations on the availability of market information. The value of participatory interests in collective investment schemes may go down as well as up and past performance is not necessarily a guide to the future. For all portfolios forward pricing is used and portfolio valuations take place at approximately 15h00 each business day (17h00 at month and quarter end) with an exception for Fund of Funds portfolio valuation take place at approximately 17h00 each business day using the underlying funds valuations of the previous day. Instructions to redeem or repurchase must reach the FNB CIS Manco before 14h00 to ensure same day value. Excessive withdrawals from the portfolio may place the portfolio under liquidity pressures. In such circumstances, a process of ring-fencing of withdrawal instructions and managed pay-outs over time may be followed. CIS portfolios are traded at ruling prices and can engage in borrowing and scrip lending. Fluctuations or movements in exchange rates may cause the value of underlying investments to go up or down. A CIS portfolio may borrow up to 10% of the market value of the portfolio to bridge insufficient liquidity. Participatory interests in CIS portfolios are calculated on a net asset value (NAV) basis, which is the total market value of all assets in the portfolio including any income accruals and less any permissible deductions from the CIS portfolio divided by the number of participatory interests in issue. All fees quoted exclude VAT except where stated differently. The Total Expense Ratio (TER) is expressed as an annualised percentage of the charges, levies and fees incurred by the portfolio related to its management, for the period under review against the average NAV of the portfolio over this period. A higher TER does not necessarily imply a poor return, nor does a lower TER imply a good return. The current TER cannot be regarded as an indication of future TERs. A full detailed schedule of fees, charges and commissions is available from the FNB CIS Manco on request and incentives may be paid and if so, would be included in the overall costs. The manager does not provide any guarantee either with respect to the capital or the return of a portfolio. The manager has a right to close the portfolio to new investors in order to manage the portfolio more efficiently in accordance with its mandate. A Fund of Funds is a portfolio that invests in portfolios of collective investment schemes, which levy their own charges, which could result in a higher fee structure. Additional information about this product, including brochures, application forms and annual or quarterly reports, can be obtained from the Manager, free of charge, and from the website: www.fnb.co.za. Ashburton Fund Managers (Pty) Ltd is an authorised Financial Services Provider.
