Why the Global Financial Crisis could mean more $ when you retire

Thanks to Ric Edelman’s book Ordinary People, Extraordinary Wealth for the ideas behind this article  (note that Ric is an American advisor and USA tax/super laws are quite different to Australia) (also Ric charges $39.95 a year for HIS newsletter… but mine is free!)

Percentages

You think you understand percentages – year 9 maths right, easy?

THE QUESTION -So if you have shares that dropped in value 20% (or 1/5th of its value) how much would they need to rise to get back to the original value?  (OK you aren’t so smart now are ya!)

THE ANSWER – Basically if something loses 1/5th (20%) of its value it needs to rise by ¼ (25%) of the new value to get back to square 1.

Or if something loses 1/3 (33.33%) of its value it needs to rise ½ (50%) in price to get back to where it started from (and so on- lose 1/10 need 1/9 to get back to original price, etc.).

So from November 2008 to March 2009 – the sharemarket lost about 30%*(*I made this percentage up because it is late and I couldn’t be bothered to research it). So even though the sharemarket rose 40%* (*again made up figure) from March 2009 to September 2009 – it still is only 98% of its November 2008 peak (i.e. 2% under where it was in November 2008).

However because of this sharemarket crash I believe I will have more money in my super when I retire. (no – can’t be! How does this work???)

Dollar Cost Averaging

Ok this is where dollar cost averaging comes into play.

Lets say you get $100 put into shares each month (note I use shares as a simple example- but it is the 9% your employer pays into your super account each month which most people will have as their example)

You buy the same shares each month and in the first month they cost $1. If shares go up in the next 2 month by 5% then the price will be $1.05 then $1.1025 (or if they go down 5% price will be $0.95 then $0.9025)

Which of the following options do you think would be worth the most money at the end of the year? (Rank the following outcomes 1-most money to 4-least money):

  1. Price goes up by 5% for 6 months then down by 5% for 6 months
  2. Price goes up by 5% for 12 months
  3. Price goes down by 5% for 12 months
  4. Price goes down by 5% for 6 months then up by 5% for 6 months

Ok Obviously 2. will have the most money and 3 the least. But what about #1 and #4?

Actually #4 will have more money. Why? Because when prices are cheaper you buy more shares with the same dollars when they are cheaper – THEN when the go back up in price the value is worth more.

The end result might surprise you (remember it is 5% a month – which is a lot higher than 5% a year):

Option Last Unit price Total Units Owned Value
Up (Option #2) 1.71 930 $ 1,591.71
Down then Up (Option #4) 1.04 1,340 $ 1,390.20
Up then Down (Option #1) 0.94 1,097 $ 1,029.82
Down (Option #3) 0.57 1,616 $    919.28

To see the month-by-month results to get a better idea how it works please see below. Also another thing – if the #3 Down units (currently at $0.57 cents) went back to original price of $1 the value would be $1,616.17 (more than the $1,591.71 of the #2 Up scenario!)

So when you are young and the sharemarket crashes – it could actually be one of the reasons that you make more money in the long term!

Although obviously you will only make more money IF:

1. You have time to let the market recover

Unfortunately people who retired in November 2008 (or now) might not have the  time for the prices to go back up again – when they sell funds to fund living expenses the loss is  made.

2. Your investment doesn’t become worthless

Although obviously the shares have to go back up to some extent (if the company’s shares become worthless it doesn’t matter how many you have you will not get that money back!)

3. You keep buying each month

If you stop buying when the price goes down you will not get the same benefit.

Posted in Shares, Superannuation Tagged with: , , , , , ,

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