By John Kay
Published: January 23 2009 17:17 | Last updated: January 23 2009 17:17
Here is a scheme for beating the market that really works. Imagine a volatile share that sells for 50p in odd years and 100p in even years. If you invest £100 every year in this share, over a 10-year period you will have accumulated 1,500 shares at an average price of 66.7p, well below the average market price, which is 75p.
This system will, on average, outperform the market and, the more volatile the markets, the greater the gains. The method is known as pound cost averaging. It works through its built-in mechanism for buying more when prices are relatively low and less when prices are relatively high. No judgment is required by the investor that prices are relatively low or relatively high.
Many individuals do, and more should, make regular savings to build up an investment portfolio. Some investment managers use the benefits of pound-cost averaging and extol the benefits of a regular savings scheme in their marketing literature. On this occasion, believe them. The benefits are real. But keep an eye, as usual, on their charges.
The effectiveness of pound-cost averaging illustrates how low share prices are an opportunity rather than a problem for the intelligent investor. Conventional investors are usually excited when they hear that the market is going up, disappointed when they learn that it has fallen. We want high prices when we are sellers, but low prices when we are buyers. We are usually only buyers of clothes or durable goods. However, for shares – as perhaps for cars and houses – we may be both buyers and sellers at different times.
When should the intelligent investor sell? The simple answer is "Not very often". Frequent trading endangers returns.
Pound-cost averaging makes sense for both conventional and intelligent investors. Conventional investors can feel relieved that their approach yields profits without requiring judgment.
Intelligent investors know that market timing is unlikely to make money and can feel happy with an approach that is inherently contrarian. The reasoning that makes pound-cost averaging attractive applies to decisions about asset classes as well as to decisions about market timing.
Individual investors may choose to follow the market allocation; institutional investors feel obliged to follow it. Such benchmarking has led to a steady increase in the share of equities, the best performing asset class, in conventional portfolios. The consequences can be perverse. At the peak of the Japanese stock market bubble of the 1980s, Japanese shares accounted for almost half of the value of all in the world. American and European investors, who had thought they were brave if 10 per cent of their assets were in Japan, felt under pressure to acquire more securities in Japan. Fifteen years later, Japanese share prices had fallen, while those in other countries had risen. Today, Japan accounts for less than 10 per cent of the market value of world indices.
Many investors have been victims of milder versions of the error, buying technology shares, bonds, infrastructure and property at the wrong times. Looking at market weightings when deciding asset allocation leads institutions and fund managers to buy high and sell low. They purchase overpriced assets in order to achieve desired portfolio weightings.
Intelligent investors look behind the financial assets they buy to the value of the productive assets that underpin them. A benchmark for allocation to Japan might, therefore, be Japanese national income as a percentage of world national income, implying a range of 5 per cent-10 per cent that would remain unchanged by the vagaries of the Japanese stock markets.
From this perspective, an indexed portfolio contains a heavy concentration of oil companies, pharmaceutical businesses and financial companies, relative to the economic importance of these activities. Very large economic sectors, such as agriculture, education, health care, and legal and accounting services, are not represented at all in the model pension fund portfolio – or only in very limited ways.
You can change that. There are few quoted securities in agriculture, education or health, but there are some. Although there are (as yet) no stock market prices for law firms or accountancy practices there are other businesses, such as recruitment agencies and public relations firms, whose fortunes are closely related.
The illuminating insight is that investors should be wary of allowing fluctuations in market prices to influence their target allocations to different asset classes. If the price of property rises relative to the price of your other assets, consider reducing the proportion of your assets you hold in property, and vice versa. Many people find this paradoxical. Should we really sell securities just because they have done well? In a world characterised by momentum and mean reversion, you should. That way you can realise the benefits of pound-cost averaging in asset allocation as well as market timing.
This system will, on average, outperform the market and, the more volatile the markets, the greater the gains. The method is known as pound cost averaging. It works through its built-in mechanism for buying more when prices are relatively low and less when prices are relatively high. No judgment is required by the investor that prices are relatively low or relatively high.
Many individuals do, and more should, make regular savings to build up an investment portfolio. Some investment managers use the benefits of pound-cost averaging and extol the benefits of a regular savings scheme in their marketing literature. On this occasion, believe them. The benefits are real. But keep an eye, as usual, on their charges.
The effectiveness of pound-cost averaging illustrates how low share prices are an opportunity rather than a problem for the intelligent investor. Conventional investors are usually excited when they hear that the market is going up, disappointed when they learn that it has fallen. We want high prices when we are sellers, but low prices when we are buyers. We are usually only buyers of clothes or durable goods. However, for shares – as perhaps for cars and houses – we may be both buyers and sellers at different times.
When should the intelligent investor sell? The simple answer is "Not very often". Frequent trading endangers returns.
Pound-cost averaging makes sense for both conventional and intelligent investors. Conventional investors can feel relieved that their approach yields profits without requiring judgment.
Intelligent investors know that market timing is unlikely to make money and can feel happy with an approach that is inherently contrarian. The reasoning that makes pound-cost averaging attractive applies to decisions about asset classes as well as to decisions about market timing.
Individual investors may choose to follow the market allocation; institutional investors feel obliged to follow it. Such benchmarking has led to a steady increase in the share of equities, the best performing asset class, in conventional portfolios. The consequences can be perverse. At the peak of the Japanese stock market bubble of the 1980s, Japanese shares accounted for almost half of the value of all in the world. American and European investors, who had thought they were brave if 10 per cent of their assets were in Japan, felt under pressure to acquire more securities in Japan. Fifteen years later, Japanese share prices had fallen, while those in other countries had risen. Today, Japan accounts for less than 10 per cent of the market value of world indices.
Many investors have been victims of milder versions of the error, buying technology shares, bonds, infrastructure and property at the wrong times. Looking at market weightings when deciding asset allocation leads institutions and fund managers to buy high and sell low. They purchase overpriced assets in order to achieve desired portfolio weightings.
Intelligent investors look behind the financial assets they buy to the value of the productive assets that underpin them. A benchmark for allocation to Japan might, therefore, be Japanese national income as a percentage of world national income, implying a range of 5 per cent-10 per cent that would remain unchanged by the vagaries of the Japanese stock markets.
From this perspective, an indexed portfolio contains a heavy concentration of oil companies, pharmaceutical businesses and financial companies, relative to the economic importance of these activities. Very large economic sectors, such as agriculture, education, health care, and legal and accounting services, are not represented at all in the model pension fund portfolio – or only in very limited ways.
You can change that. There are few quoted securities in agriculture, education or health, but there are some. Although there are (as yet) no stock market prices for law firms or accountancy practices there are other businesses, such as recruitment agencies and public relations firms, whose fortunes are closely related.
The illuminating insight is that investors should be wary of allowing fluctuations in market prices to influence their target allocations to different asset classes. If the price of property rises relative to the price of your other assets, consider reducing the proportion of your assets you hold in property, and vice versa. Many people find this paradoxical. Should we really sell securities just because they have done well? In a world characterised by momentum and mean reversion, you should. That way you can realise the benefits of pound-cost averaging in asset allocation as well as market timing.
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