Three ways to make great investing decisions

Summary: Life would be much easier if the returns from sharemarkets followed a straight line (to the upside). However, as we deal with the reality of volatility, there are three mathematical concepts we should keep in mind. 

Key take-out: These simple tips come in handy when making regular investments, when working out the role of compound interest, and when determining the importance of keeping cash in a portfolio.

A little market volatility makes for interesting times, and can create a new sense of urgency to make good investment decisions.

But a better understanding of maths is often needed to be opportunistic and make great investment decisions. Naturally, it can help to do the math on regular investments, compound investments, and when looking closer to the role of liquidity in a portfolio. 

Regular investment math

A quick quiz. If you buy $1000 worth of shares at $10, and then another $1000 worth of the shares at $5, what is the average price of the shares you own? 

The common answer is $7.50.

Here, however, is an important lesson in the power of investing regularly over time. And this is what many people are doing as they make regular investments into their superannuation fund.  

For 100 shares purchased at $10 a pop, an investor gets $1000 worth of shares. Another $1000 worth of shares at $5 will get you a further 200 shares. So, for $2000, this investor has purchased 300 shares, giving them an average price per share of only $6.67.  

Because you effectively buy twice as many shares when you invest when the share price is lower, you lower your average cost of shares more quickly than most people realise.

It is not often that we get to buy shares when they have fallen in half – the notable recent example being the fall in the market from around 6800 points to the low 3000-point range during the global financial crisis. But keeping in mind how effective regular contributions can be at lowering the average cost of our investments might just help us to ‘be greedy when others are fearful' (the words of Warren Buffett).

The magic of compounding interest

If you invested $100,000 over 20 years, to the end of 2016, in an average superannuation fund, it would have turned into $560,000. That's the average rate of return for Australian shares in the superannuation environment of 9 per cent per annum, according to the ASX Russell Long-term Investing Report.  

The ‘magic' of that figure might even be undersold. During that 20-year period, we had the GFC, which halved the value of Australian shares, and then some overseas, and yet still investors who held their nerve would have received a very satisfactory market return.

Albert Einstein famously quipped that compound interest was the ‘eighth wonder of the world'.

In times of market volatility, it is possible to forget the basics of how compounding works – it is the reinvestment of income into a portfolio (or investment) to buy more. Over long periods of time (15 years or more), markets produce compelling evidence that they truly can be compounding wealth-creating machines.

The challenge with volatility is that people get nervous about the headlines and sell assets. This leads to the ‘anti-compounding' effect of generating transactions costs, generating tax costs (capital gains tax), and running the risk of being out of the market during periods of positive returns. 

Dalbar, a US-based financial services company, conducts an annual study of the returns that managed fund investors produce from investing across different asset classes, including shares. 

Over the 30 years in the US, to the end of 2016, the return from investing in the average portfolio shares on the S&P 500 index was 10.16 per cent per annum, a return that would have turned $100,000 into $1.182 million.  

However, Dalbar calculated the average investor in managed funds received a return of only 3.98 per cent, effectively turning $100,000 into a far more modest $322,000, largely because of their decisions to buy and sell at the wrong time, which in turn eroded the magic of compound interest. It's clearly important to choose the right fund manager.

Compounding interest does seem to yield impressive results over long periods of time. As investors, we need to be aware of any ‘anti-compounding' behaviour that reduces our exposure to this phenomenon. Choosing to sell during volatility and downturns would seem to be a common ‘anti-compounding' mistake.

The role of liquidity 

There's an old saying that cash helps you sleep, while shares let you eat.

But as simple as this saying might be, it slightly understates the role of cash. A nice cash reserve in a Government guaranteed bank account provides a great deal of relief when there is market volatility around. It also plays the important role of stopping you from being a forced seller of an asset in a downturn.

Consider someone who wants to use a portion of their $1 million in retirement savings to buy a $25,000 car. The total cost of the car is, effectively, 2.5 per cent of their total savings. However, let's assume the sharemarket falls by 20 per cent, a level of decline that is not uncommon, and suddenly the $25,000 car requires you to give up 3.13 per cent of your now $800,000 sharemarket portfolio. Of course, in the more dramatic circumstances of the 50 per cent market fall we saw in 2007-09, a car purchase that was 2.5 per cent of the portfolio value becomes a purchase costing 5 per cent of the portfolio value.

We are lucky in our Australian context. We have a relatively high-income paying sharemarket and the tax benefits of franking credits allow attractive retirement cash flows. Factor this into keeping a modest cash reserve that provides protection in a downturn and you immediately have a more resilient financial position.