In this week’s blog, I will be discussing the subject of “Phasing In.” Phasing In is a strategy employed by a number of financial planners to mitigate risk within a client’s portfolio, especially during times of market uncertainty.
The objective of using a Phasing In strategy is to try to guard against buying into the top of the market. Consider the situation where an investment is made, and the market declines by 20% the following day. If a phasing approach had been followed, only a portion of the investment would suffer the 20% drop, and the next portion would be invested at the now lower cost – leading to better returns. The opposite is also true, though. If an investment is phased in during a rising market, each subsequent portion will be invested at a higher cost, leading to decreased returns.
Phasing does, however, mean that your money is out of the market for longer than it would be when investing a lump sum. Since markets in general increase in value, this would mean that on average, phasing in should deliver lower returns than a lump sum investment. It would seem, then, that phasing in may be seen as a risk-mitigating strategy. How effective is it, though, and what is the cost of this “insurance?”
The results from an analysis done by Professor Bill Jones on the US equity market for the period from 1953 to 1996 make for interesting reading. He tested phasing in an investment over 6, 12, 18, 24, and 36-month periods.
Before presenting the numbers, he comes to a few logical conclusions:
- Phasing in is to protect against a substantial drop in value in the first few months after a lump sum investment.
- Phasing in over 6 months works well when the drop happens in the first 2 or 3 months, since half the money will be invested at lower cost. If the drop happens in the 5th or 6th month, or even after that, phasing in would not have been effective.
- Phasing in over 12 months is effective if the drop happens in the first 8 months. He concludes that a drop after that shouldn’t, in general, have much of an effect because the 8 months of increasing value should offset any decline in value after that.
- Phasing in should not be used over periods longer than a year. Suppose you had decided to phase in over 24 months and you have a decline in the first 6 months. The phasing in would thus seem like a success. The problem is that it is likely that the market will recover in the remaining months, and so all subsequent amounts are being phased in at higher prices.
Phasing in will protect an investor from losses that would have been suffered if a lump sum had been invested. This protection does, however, come at an average cost of 1.11% over the 6-month period. From the analysis, Jones concludes that the best balance between protection against loss and the cost of this protection is obtained by phasing in over 6 to 12-month periods.
In conclusion, we can draw the following conclusions and guidelines when thinking about phasing in a lump sum investment:
- Investing in a volatile asset class such as equities is a long-term decision, as many years are needed to smooth out the volatility inherent in the market, allowing the investor to earn the average return of the market.
- Markets are and will remain uncertain, and no investment strategy is guaranteed to work all the time every time.
- Because markets trend upwards on average, phasing in will mean a lower return than a lump sum investment as the investor is out of the market for a period when phasing in.
- Phasing in looks to be effective as a risk mitigation strategy. As with any risk mitigation strategy, both risk as well as return will be reduced, and a decision will need to be made as to whether the cost is worth it.
- Phasing in outperforms a lump sum less than 40% of the time.
- When a lump sum loses money, phasing in does provide protection against the loss.
- If phasing in is used, a period of between 6 and 12 months seems to be the optimal trade-off between risk and return.
Information courtesy of ACSIS and Nedgroup Investments.
