Double-edged sword

Written on the 8th of February 2009 by Robin Bowerman, Smart Investing, Principal & Head of Retail, Vanguard Investments Australia

The Reserve Bank's cutting of official interest rates last week to a 45-year low is certainly great news for everyone having to meet repayments on a hefty mortgage.

Making a few assumptions, Commsec's chief economist Craig James has done a little number crunching: "The unprecedented rate cuts over the past five months translate to a massive pay rise for the home-buying public. Since September, interest rate repayments on a $300,000 loan have fallen by $8,800 a year - effectively representing a 15% pay increase for someone on the average wage."

But as with a lot of things in life, there is a double-edged sword with the fast-falling interest rates.

Investors who had tried to time the sharemarket by shifting to all-cash portfolios are now paying one of the costs. The earnings on their cash holdings have been hit extremely hard.

As regular readers would know, this column has a few favourite themes with one of them being the perils of market timing - that is trying to pick the best time to buy or sell shares. Even the most seasoned market professionals usually fail in any attempts to time the market. And when they do succeed on occasions, it seems more a matter of luck than anything else.

The key pitfalls from market timing including selling stock at depressed prices, missing out on the initial bounce when the market begins to recover, and incurring unnecessarily taxes and transaction costs.

And a sharp drop in interest rates is a much overlooked extra peril arising from market timing.

Of course, the amount of cash that an investor holds as part of a carefully constructed asset allocation has nothing to do with market timing. As an investor grows older, quality financial planners generally reinforce that their asset allocation between growth assets (mainly shares) and defensive assets of bonds and cash should reflect their changing tolerance to investment risk.

Interesting, superannuation fund researcher Chant West has just released its survey of pension fund returns for the December quarter, highlighting that Australian and international bonds produced strong positive returns against "savage losses" in the sharemarkets.

Indeed in his report, Chant West principal Warren Chant points out that 60% of the super funds in the firm's database use the same default option (61-80% exposure to growth assets) for pension members as those still in the accumulation phase.

"There is a case for these [pension] members - all aged 55 or over by definition - to consider a less-aggressive investment mix," Chant writes. "While their investment timeframe may still be quite long, they generally don't have the capacity to top up their savings from fresh contributions."

The issue, discussed by Chant, is certainly different to market timing. And investors, including super fund members, getting their correct asset allocation to cash and bonds should not confuse the two.