In the interests of trying to be money smart, what do you think of my theory for my son?
He is studying at uni and this year has been made an assistant at his hall of residence, so he does not have to pay accommodation. This greatly reduces the student loan he needs for his living costs.
I started all the kids up in KiwiSaver some years ago and want them to make contributions as soon as they can. I think it would make sense for him to take out some extra "living costs" by way of his student loan and for him to put this into his KiwiSaver so he gets the Government contribution now he's old enough. I think if he can do this over the next three years, this will help him on the track towards the HomeStart scenario as well.
Is this correct or am I missing something? Surely it must make sense for him to be putting contributions in from interest-free (at the moment) money and then getting the top up?
Your thoughts would be appreciated.
No, you're not missing anything. Your son will probably be able to do what you're planning. But should he? Let's look at the rules first.
"The Student Loan Scheme is designed to enable access to tertiary education for people who would otherwise not be able to afford to do so," says a spokeswoman for the Ministry of Social Development.
"We encourage students to only borrow what they need, as the loan is repayable and is provided by the Government to enable access to tertiary education."
However, there are no income or asset tests for student loans.
"Eligible students do not need to justify or describe why they need to borrow what they borrow, and there are limits to what a student can borrow."
She adds: "We can consider suspending or refusing access if we have grounds to believe a person is or intends to use a student loan for other than its stated purpose."
In light of that, I'm not going to say your son should borrow to invest in KiwiSaver. But I can see why it's tempting.
If a person you trusted — so you know it's not a scam — offered to lend you money interest-free and then subsidise the investment you made with that money, of course you would do it. Does it make any difference that it's the Government — aka your fellow taxpayers — that's being so generous?
When student loans first became interest-free, I told off people in this column who were borrowing money they didn't need and banking it. After they graduated, they paid off the loan with that money, and kept the compounding interest earned.
But since then I've heard of many people doing similar tricks. It seems unfair to tell those with a conscience they shouldn't do it when others are laughing about how good the deal is.
There's no easy solution to this. If we made students prove they needed the money for living costs, that would involve labour-intensive administration. And even then, clever people would find a way around it. We could get rid of interest-free student loans, but that would make it pretty much impossible for many people to study.
In the end, each person — and, in some cases, their mum — has to decide what's okay for them.
Once again I have to admonish you for your claim that dollar cost averaging (DCA) "brings down your average price". It doesn't.
On average, the price goes up and so any timing method such as DCA that delays entry into the market must, on average, increase the price. It's that simple.
Delaying your entry so as to average a lower price is market timing, which, as you know, doesn't work. DCA doesn't pick highs and lows so is more likely to randomly hit highs than lows (because of the upward trend).
I think you should publish a retraction. Not just because the statement is plain wrong but because it is a widely-held misbelief.
Goodness me. I feel as if I've been called into the headmaster's office.
"But please, Sir! I'm not guilty."
Last week's letter was from a reader with $200,000 to put into an index fund. He was considering whether to invest the lot in one go or invest just $500 or $1000 a month over a long period.
I said DCA works with any investment whose value goes up and down. "With dollar cost averaging you invest the same amount regularly — perhaps monthly or every payday.
That means you'll buy more units in the fund when they are cheap, and fewer when they're expensive." That's the context in which I added, "That brings down your average price."
And there's no denying that. It's straightforward maths. It works even in a rapidly rising sharemarket with no downward blips.
Let's say that you invest $1000 every two months for a year, and the prices per unit are: $100, then two months later $104, then $110, $118, $125 and finally $130.
Your $1000 buys you 10 units the first time, when the price is $100. The next time it buys about 9.6 units, then 9.1, then 8.5, then 8, and finally 7.7.
A calculator tells us that the total number of units you have bought is 52.9. And the average price of those units is $114.50.
So you would think you would have paid $114.50 times 52.9 units, or a total of $6057.05. But you've actually paid only $6000 — a lower average price, as I said.
However, what I think you're getting at is that, if you have a lump sum at the start, you should compare DCA with investing the lot on day one. And if the market is rising, investing fully from the start gives you a bigger advantage than the reduced average price of DCA.
The opposite applies if the market falls. DCA wins then. But given that markets rise more often than they fall, you generally end up with more money if you invest the whole lump sum at the start.
I did acknowledge that last week, by saying: "But the downside in your situation is that, in the meantime, you have lots of money probably earning a pittance in a bank term deposit, when it could be earning more on average in the index fund.
I suggest you compromise. Drip feed equal amounts — $16,667 a month — into the index fund over a year, rather than the many years you are proposing."
Still, I should have made a bigger deal out of missing out on higher returns in the investment than out of it.
US fund manager Vanguard did some research over 10-year periods that confirms what you say — on average you end up with more money if you invest a lump sum upfront rather than drip-feeding it.
However, the difference between the two strategies was small. The lump sum investor ended up with 2.3 per cent more in the US, 2.2 per cent more in the UK, and just 1.3 per cent more in Australia.
And you're ignoring two really important psychological points. The first is that if someone is going to invest a large sum all at once, they will probably worry that the market will fall soon afterwards.
That fear can keep people on the sidelines — in a bank account — for months, whereas if they had drip-fed the money they would probably get on with it.
The second psychological point is that lots of research shows that most people want to avoid investment losses more than they want to make gains. Let's say there's a choice between:
• An investment that will do well most of the time, but there's a fairly big chance it will do badly.
• An investment that will bring in middling returns overall, and usually do somewhat worse than the first option.
Many people will choose the second one. To see how people dislike volatility and uncertainty, just look at all the money New Zealanders hold in bank term deposits.
When you use DCA, you are going with the second option. It's comforting to know the prices will average out, and that you will be able to look back and say: "At least some months I got a good price."
As the Vanguard researchers put it: "Risk-averse investors may be less concerned about averages than they are about worst-case scenarios, as well as the potential feelings of regret that would occur if a lump-sum investment were made immediately prior to a market decline.
"These concerns are not unreasonable. We found that DCA performed better during market downturns, so DCA may be a logical alternative for investors who prefer some short-term downside protection."
It's not all about maximising your money, but also about investing comfortably.
A couple of other points about DCA:
• If you commit to investing on, say, the first of every month regardless of what the markets are doing, you will sometimes buy right after the market has fallen. Without that commitment, that might feel counterintuitive, but it's actually a good tactic, because you will often get low prices.
• As I said last week, many people in KiwiSaver or other savings schemes don't have the option of investing a lump sum at the start. But drip-feeding into their accounts works well anyway.
So where are we with the headmaster? How about, "Okay, Sir, I promise to be more careful with my wording on this topic in future. Now can I please go out and play?"
Watch for fees
You mentioned in your last article that dollar cost averaging is beneficial when investing over the long run — which it is. The return on leaving funds in the bank is minimal of course, but the benefits of price fluctuations are gained.
My point is there needs to be consideration of the brokerage fees associated with the investment. Drip feeding of funds needs to be arranged in sufficiently large values to minimise brokerage, as there is usually a minimum fee for each transaction.
Our previous correspondent might argue with your first paragraph. But enough on that!
You make a good point about brokerage or other entry costs. Perhaps, instead of investing monthly for a year, it would be better to make four or six equal investments through the year.
Or, to keep our previous bloke happy, consider investing the lot at the start. More often than not you'll do better. But don't muck around before investing. And promise yourself not to mind if the market falls after you invest.
Making it grow
Surely all KiwiSaver money should be in growth funds. My current share portfolio is earning 8 to 9 per cent per year. Sure, it will go down sometimes, but overall worldwide shares outpace inflation over the long run.
You're right — shares do beat inflation, and most people would end up with more in KiwiSaver if they used growth or aggressive funds.
But as noted above, many people can't cope with volatility and uncertainty.
- Mary Holm is a freelance journalist, a director of the Financial Markets Authority and Financial Services Complaints Ltd (FSCL), a seminar presenter and a bestselling author on personal finance. Her website is www.maryholm.com. Her opinions are personal, and do not reflect the position of any organisation in which she holds office. Mary's advice is of a general nature, and she is not responsible for any loss that any reader may suffer from following it. Send questions to firstname.lastname@example.org or Money Column, Private Bag 92198 Victoria St West, Auckland 1142. Letters should not exceed 200 words. We won't publish your name. Please provide a (preferably daytime) phone number. Sorry, but Mary cannot answer all questions, correspond directly with readers, or give financial advice.