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“If you expect to be a net saver during the next five years, should you hope for a higher or lower stock market during that period? Many investors get this one wrong. Even though they are going to be net buyers of stocks for many years to come, they are elated when stock prices rise and depressed when they fall. … Only those who will be sellers of equities in the near future should be happy at seeing stocks rise. Prospective purchasers should much prefer sinking prices.”

Warren Buffett – Berkshire’s 1997 Shareholder Letter

 

Investment returns on the local equity market have been extremely low over the last 3, 5 and 10 years, and in fact below average over all meaningful time horizons as detailed in a previous article, Poor Historical Returns from Capital Markets Set the Foundation for Superior Future Returns by Ian de Lange (view article). The JSE ALSI fell -12.6% over the past year, tempting many equity investors to exit the market and invest in lower risk options, such as income funds, instead.

According to Warren Buffett, one of the greatest investment minds of our time, long term savers need not despair when the markets fall. The concept of Rand Cost Averaging (RCA) comes to the rescue. RCA entails investing regular amounts, for instance, a monthly debit order into a unit trust or other savings account that has a variable, market related price.  At times when markets do well, the higher unit price means that less units can be bought for a fixed rand investment.  When market returns are negative, as we are currently experiencing, unit prices are low and more units can be purchased. How can RCA be applied practically? The two scenarios below look at the concept in more detail

  • Scenario 1 illustrates a stable market which delivers 10.0% pa in a straight line over 20 years.
  • Scenario 2 illustrates a market that falls by -5.0% pa for the first 10 years, but subsequently delivers +27.5% pa for the next 10 years for an equal 10.0% pa over the full 20 years.

In each scenario, the investor either applies RCA and invests R 1,000 pm consistently over the full period, or employs market timing and invests the discounted value of R 47,918 every 5 years.

Scenario 1: Stable Market

Scenario 1 – In a stable market,the returns accrue evenly, and both portfolios result in the same rand portfolio size at the end of the period.

Scenario 2:  Market Down, then Up

Scenario 2 – During the first 10 years of falling markets, the investor contributing monthly is able to achieve a lower average purchasing price of units.  This is offset to a degree by the second period of rising markets, but the RCA investor still achieves a superior outcome over the full period. 

Take note that under Scenario 2, the portfolio totals for both contribution patterns are significantly higher than under Scenario 1. This confirms Buffett’s statement – falling markets allow regular savers to accumulate assets at depressed prices while their total portfolios values are still low, and allows them to benefit from subsequent rallies when they have already accumulated some wealth

The concept of RCA neatly combines a few central investment concepts:

  • Invest for the long term and do not be distracted by news flow and the fears of others
  • Save in a disciplined, regular fashion as part of your monthly budgeting process
  • Buy low and sell high – do not stop your regular contributions when unit prices have fallen!

Kind regards,

Cor van Devener

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