We told you so.
In case you haven’t noticed, prices in the sharemarket have fallen off a bit of a cliff this week. The ASX 200 opened on Monday at around 6100 points. By lunchtime Tuesday it had fallen to 5830 points. This is about a 5% reduction – pretty nasty in just one and a half days of trading.
So what’s all this about ‘we told you so?’ Well, admittedly we didn’t predict that the market was going to tumble this week. However, we always predict that the market will fall in some weeks. Share markets are volatile, and volatility means that prices fall from time to time. This week’s fall should come as no surprise to any adviser over the age of 18.
Falls happen. We factor market falls into our investment strategies. The more formal term for inevitable price falls is ‘market volatility.’ Market volatility introduces a form of risk known as ‘timing risk.’ As the name suggests, timing risk is the risk of buying the right share at the wrong time. For example, if you were buying shares last Friday, you probably couldn’t have timed things more badly.
To an extent, timing risk cannot be avoided. If you are going to invest in the sharemarket, you have to do it at some particular point in time. This introduces the prospect that you will pick the wrong time. Happily, though, timing risk can be managed. And it can be managed in a way with which most people are familiar.
The close cousin of timing risk is ‘specific risk.’ Specific risk is the risk that you will invest in exactly (specifically) the wrong company – a company whose share price is about to fall. Specific risk is managed by diversification: rather than make a large investment in one company, you divide your money into smaller portions and make several smaller investments into many companies. If one of these companies performs poorly (and one of them almost certainly will – another one of our very confident predictions), you only lose money from that relatively small portion that was invested in that company. Over time, most companies do well, meaning that most of your portions make a positive return. Overall, this is why diversified portfolios tend to do well over time.
Timing risk can also be managed by diversification. In this case, we diversify the times at which an investment is made. Rather than invest $100,000 all at once, we divide that amount into smaller portions of, say, $10,000 and invest them at ten different points in time. If these points of time are regularly spaced, then the process is given a formal name: dollar cost averaging.
Dollar cost averaging is always our starting point when recommending a share-based investment. The only time we don’t use dollar cost averaging is when clients are moving money out of an existing share-based investment into another share-based investment. For example, a client might be moving money out of an expensive superannuation option into a less expensive industry fund or self managed superannuation fund option, through which they will make a share investment. When this is the case, the client is moving money out of the sharemarket through one manager and back into the sharemarket through another. They are selling and buying under the same market conditions. This means that timing risk is not an issue.
But when it comes to ‘new’ money being invested into the market, we always recommend dollar cost averaging. That’s why every one of the plans we have written over the last twelve months has involved this form of diversification over time. Even better, the period of dollar cost averaging is still going. That is, anyone to whom we have recommended a new and significant sharemarket investment should still have cash in the bank that has not yet been invested.
That’s why we can say ‘we told you so.’ While we can’t say we predicted the precise date of this market correction, we can definitely say that we planned for it in our client advice. In particular, because our clients still have money available to invest, we planned to take advantage of the lower prices available this week. After all, when prices fall, that’s good news for buyers. And all of our investment clients from the last 12 months are still buyers.