The difference between speculation and investment

What are the key differences in behaviour that help define the distinction between speculators and investors? What do your behaviours say about you?

Speculation has been defined as the assumption of risk in anticipation of gain. Compared to investing, it tends to be associated with higher risks and achieving quicker and larger gains. It generally involves a “bottom up” approach that treats each risk as separate and distinct. It includes elements of stock selection, market timing and forecasting.

Investment, on the other hand, employs a “top down” approach that avoids focus on the separate risks and short term outcomes in favour of a focus on the characteristics of the whole portfolio.

A casino analogy

A good example for highlighting the distinction between investment and speculative behaviour is the interaction between a casino operator and its players. The behaviour of the casino operator is likened to that of an investor and the player to that of a speculator.

Casinos rely on getting an outcome in line with their expected advantage. For example, their payouts are set at (say) 97% of the fair odds for each bet. Accordingly, they expect to get a return of 3% on each bet.

Of course, there’s no guarantee that the casino will get their expected 3% return for any game or on any given day. This is what makes it such an alluring proposition for the player.

The casino operates on the principle of the Law of Large Numbers. This says that as the number of trials (bets) increases, the average return should converge towards the expected return (3% per bet). As the casino’s return converges towards the expected return (3%), the collective return of all players converges towards the opposite of that return (-3%).

Casinos tend to have more longevity than their players. While they may experience some extreme movements in their short term returns, they are prepared to diversify their risk across players and games. They don’t care who is winning or losing as long as players keep betting. They take a broad and long term perspective.

The players’ behaviour on the other hand is quite different. Each bet is seen as a separate and distinct bet. They use various complex betting strategies involving forecasting, trend following, hedging and leverage. They are optimistic about their abilities to make money in any game. This is despite the fact that as a collective group, their average return will converge towards -3%.

Access to information is often considered a key ingredient to successful investing. How does this apply to the casino analogy?

You can imagine the casino has the ability to easily tell which numbers on a roulette table pay out more frequently. Surely, with this (privileged) information they should be able to easily add value by adjusting the specific odds to their advantage (e.g. by shifting the odds to encourage players to bet on less successful occurrences).

Yet, they don’t bother to change their payout odds. Most speculators would consider this a missed (golden) opportunity. Yet the casino behaves as if the specific outcomes of each event don’t even matter.

The behaviour of the players infers a belief system that says they can defy the odds. In fact, its highly probable that an individual player will be well ahead for a period of time. Its equally probable that that individual will be well behind for a period of time. However, the more often they bet, the more they become subject to the Law of Large Numbers.

There is no magic that allows a specific group of players to systematically out perform the odds without relying on others to systematically under perform.

Lessons investors take from casinos

The behaviour of investors (casino operators) and speculators (casino players) in investment markets (gambling) has many similarities. If you substitute the names in the above text you’ll get an idea of the key differences.

Given that most people will have a lifelong association with investment markets, we recommend they take advantage of the Law of Large Numbers and adopt the behaviour of an investor:

1. Take a long term view and allow the Law of Large Numbers to work for you. The aim is to achieve the expected rate of return for the least cost;
2. Avoid the allure of opportunities that attempt to defy the odds (e.g. low risk, high return promises). Speculators provide liquidity to the market and spend most of their time trading with (and against) each other at a much higher cost;
3. Choose your risk strategy carefully and change it rarely;
4. Avoid getting caught up in short term returns. Be prepared to accept some volatility;
5. Don’t bother trying to predict short term pattern anomalies; and
6. Diversify across investment options and across time.

While the speculator may appear to be having more fun and employing more “intelligent” strategies, it is the investor that is playing the game with real intelligence and achieving the more certain and efficient long term return.

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Are You A Speculator Or An Investor? is a post from: Wealth Foundations Blog

Surely, I’m better off investing in my employer’s shares

Many employees hold shares (and/or rights to buy shares) in their share market listed company employer. The interest may have been acquired as part of their remuneration package or as compensation for sale of a business to the employer. Or, perhaps, the employee was optimistic about the prospects for the employer and bought its shares as an investment.

Often, there are restrictions imposed on dealing in the shares, at least for a specified period after acquisition, so the employee has no alternative but to retain the position. However, even when there are no restrictions, many employees continue to hold and, over time, build substantial (but minority) interests in their employer.

There are a number of reasons that may explain this behavior. One is that the employee simply fails to manage the position, effectively putting the shares in the “bottom drawer” hoping they will accumulate into a nice little nest egg.

Often, it is because the employee believes they are taking a stake in a business that they know intimately, are comfortable with and believe their presence will enhance the company’s performance. They also may have the view that if things go wrong, since they are on the “inside”, they will be able to get out early.

And, finally, there may be significant tax payable if the shares have done well and are sold. Why would you sell high performing shares to buy something that may not do so well and create a serious tax liability for yourself?

There is no doubt that many employees have accumulated significant wealth from receiving and holding shares in their employer beyond any minimum restraint periods. However, there are probably many more that have seen their financial futures jeopardised or even ruined by such a practice.

Too many eggs in one basket …

We think that voluntarily holding a substantial part of your investment wealth in your employer is, generally, not smart wealth management practice.

The psychology that attracts many employees to owning significant holdings of their employer’s shares is similar to that which attracts people to purchase investment property, usually in a location they know well. The familiarity factor provides comfort and a sense of control. But the control is largely illusory.

While an employee may know a lot about their employer’s company and its prospects, it is unlikely that they will know more than the market wisdom that collectively determines the company’s current share price. However, it is what you don’t know that is likely to catch you out. Taking a large bet on a single share offers the chance to make you very wealthy or, perhaps, much poorer. At any point in time, you have no idea what the outcome will be.

But, the reality is that individual shares are considerably more risky than the overall share market. They carry specific industry and company risk that is diversified away at the total market level. Modern portfolio theory explains that you cannot expect to be compensated for such diversifiable risk. While the opportunity to earn higher expected returns always requires taking higher risk, unfortunately it does not follow that the higher risk of individual shares should result in higher returns.

Individual shares do offer the small chance of doing much better than the market. But it is more likely they will do worse and, perhaps, considerably worse. In fact, unlike the total market, individual companies regularly go out of existence. Witness, Allco, Babcock & Brown, ABC Learning, Lehman Brothers etc. Their employees generally didn’t see the total demise coming until it was too late.

So the concentration risk associated with a large share holding in your employer doesn’t make good wealth management sense to us. But to add to the problem, you may also put in jeopardy what may be your most valuable asset – your future earnings potential. It is not unusual that when a company and its industry faces financial difficulties, often simultaneously, employees lose their jobs or, at least, expected career progression slows.

So, there is a potential double whammy. At the same time as your investment wealth declines due to a fall in your employer company’s share price, the value of your human wealth or projected surplus capital also falls. So closely aligning your investment wealth with your human wealth is a risk that’s just not worth taking, if it can be avoided.

Reduce your exposure to your employer

It is difficult to reduce the exposure of your human capital to your employer. But, given that, sensible wealth management that is focused on protecting and nurturing rather than maximising (and potentially destroying) wealth dictates minimising exposure to your employer company’s share price.

It also suggests the need to:

• develop a personal financial plan that aims to make your financial future as independent of the fortunes of your employer as is realistically possible, as soon as possible; and

• implement an investment strategy that takes account of and seeks to offset the significant additional risk implied by a large concentrated share holding.

And, you should know exactly how you are going to reduce your exposure, once any restrictions on dealing in your company share holdings are removed. Of course, tax consequences will need to taken into account, but they are unlikely to be an overriding consideration.

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Don’t fall in love with your employer is a post from: Wealth Foundations Blog

Most people insure their motor vehicles, their homes and their home contents. These are valuable assets that, in the event of various catastrophes, they want to be able to replace or repair without significant financial loss.

But when it comes to what is many people’s most valuable asset – their ability to earn future income – they are woefully positioned to cope financially with catastrophe. Research completed in 2006 indicated that only 55% of Australian families had any life insurance, with an even lower 31% having income protection.

Even for those with some personal risk protection, the amount of cover is generally inadequate. There are numerous reasons for this unwillingness to adequately insure, including such “rationalisations” as:

• I’d prefer not to think about negative possibilities;
• I’m healthy, it won’t happen to me;
• I’m covered by my super, workers compensation, health insurance, “the government” etc;
• Insurance is just too expensive.

We help our clients achieve their version of financial independence. But no family can ever consider itself financially independent if the death or disability of a family member requires a significant adverse change in lifestyle expectations, due to inadequate financial resources.

The reality is that many families, particularly those with breadwinners early in their careers, just cannot afford not to purchase personal risk insurance. And sometimes lot’s of it, as we discuss in the case study below.

A life insurance case study

Let’s consider the hypothetical case of Mr John Professional. John is 35 years old and intends to work until age 65. He is the expected sole income earner in his family, also comprising his wife and two young children. The Professionals currently have no net investment wealth – all their current wealth is tied up in lifestyle assets (i.e. residence, cars etc).

Listed below are some other assumptions relevant to considering John’s life insurance requirements:

The following chart shows what happens to income, expenditure and investment wealth, assuming the Professionals’ lifestyle expectations are not affected by personal catastrophe.

It shows the Professionals will accumulate a peak investment wealth of about $6.9 million that is gradually run down to finance a desired lifestyle in retirement. Everything’s rosy. However, if John were to die tomorrow, a large future expenditure requirement would remain without the valuable asset of John’s income to support it.

The chart below shows:

• Desired annual expenditure, if John dies; and
• the total capital sum required to fund the family’s spending in each future year. With no investment wealth, it is the amount of life insurance needed so the family can finance its lifestyle expectations.

An initial term life insurance requirement of $5.25 million is indicated! Often, the reaction to such analysis is first, disbelief with the amount and, second, “I can’t afford that”. But any lesser sum would require John’s family to make adjustments to their lifestyle expectations (out of financial necessity). And John can easily afford it, as we examine below.

What is the cost of life insurance?

The table below shows the cost of insurance for a healthy, male non-smoker, at various ages as quoted by a prominent life insurance provider.

It shows insurance costs accelerate rapidly with age. For example, $5.25 million of life insurance, at age 55, would cost over $25,000 a year. And, if the insurance is held outside superannuation, this is the after-tax cost i.e. it consumes almost $47,000 of a top marginal tax rate payer’s pre-tax income!

But this does not reflect John’s position. If all goes to plan, the insurance need declines with age as:

• Investment wealth increases; and
• Future expenditure requirements decline.

 
The chart below shows the interaction of insurance need and investment wealth. To about John’s age 59, the green line represents the capital sum required to meet the family’s lifestyle in the event of John’s death. It is met by a combination of insurance and increasing investment wealth. Initially, it can only be met by insurance but, by John’s age 59 and beyond, investment wealth alone is sufficient to meet the family’s expected requirements.

The purple line and right hand axis show the cost of meeting the declining insurance need. It rises to a peak of a little over $6,000 p.a. at John’s age 52 and then reduces rapidly as investment wealth overtakes insurance as the primary means to support desired lifestyle expenditure if John were to die.

Life insurance: the gamble you expect and want to lose

In fact, the lifetime cost of cover is about $82,000 or only 1.2% of the Professional’s projected peak investment wealth, assuming no catastrophe. It is easily affordable.

Insurance is a gamble that you both expect and want to lose. But for most people, it should not be a difficult decision to allocate 1.2% of expected investment wealth to avoid financial disaster for the family if the major breadwinner dies with no or inadequate insurance.

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Have you protected your most valuable asset? is a post from: Wealth Foundations Blog

Two alternative strategies that many investors consider are:

• borrowing to invest (i.e. entering into a gearing strategy), outside super; and
• increasing pre-tax contributions to super and investing in the superannuation environment.

Which is best? The comparison is not straightforward, but is often hijacked by raising the issue that your money is “locked away” in super. For those some years away from being able to access their super, this is often a compelling point in favour of gearing.

But to give gearing strategies the best chance to succeed, the investor needs a long investment horizon – at least 10 years. They need to mentally lock their money away.

Having the flexibility to access your capital often makes it harder to maintain the long term discipline so essential to being a good investor. We think accessibility is an over rated issue.

How do I choose between a gearing and super strategy?

We have used an example to help identify what we think are the main issues to consider. John and Jenny, both aged 39, have identified their expected surplus cash flows over the next 25 years. They feel they can each comfortably forego gross salary of $10,000 a year and are considering two options:

1. a “super strategy”, where they increase their pre-tax contributions to super by $10,000 p.a. each ; and
2. a “gearing strategy”, where they borrow $285,714 to invest in a jointly owned portfolio. The interest payments on the loan are assumed to be tax deductible and amount to $20,000 p.a. (i.e. an interest rate of 7.0% p.a.)

In both cases, funds are invested in a high growth portfolio with identical risk and return characteristics.

The chart below shows the movement in investment wealth over the following 25 years for each strategy:

The gearing strategy slightly outperforms in the earlier years. However, the tax advantages of investing in the super environment results in the super strategy being marginally better over the entire period.

You could conclude from this simple comparison that gearing is better suited to shorter time frames and super to longer time frames. However, this conclusion ignores the fact that the gearing strategy is riskier.

Borrowing brings forward future savings (via the use of a loan) and invests the lump sum today, compared with regular, smaller instalments to super and investment over time. It is riskier because more capital is exposed to market related risk for longer. Given the higher risk, to choose the gearing strategy you should expect it to do much better than the super strategy.

In fact, based on the assumptions used in our example, on a pre-tax basis the gearing strategy outperforms the (ungeared) super strategy by more than 66% over the 25 year period, reflecting the additional risk. Yet, after-tax, the super strategy out performs the gearing strategy by 5%, implying its tax advantages are considerable.

It is ironic that many investors are persuaded to choose gearing over super because of the former’s purported tax effectiveness.

Ignoring risk means you are comparing apples with oranges

Typically, as in the above analysis, most investment strategy comparisons ignore risk. While this helps to simplify decision making, it invariably reduces the quality of those decisions.

To compare the risk of the gearing and super strategies, we assumed some variation in the annual returns of the investment portfolios. Rather than annual returns remaining the same each year, we assumed that they would vary across a range of outcomes determined by the portfolios’ volatility, which we assumed as 15% p.a.

We then generated 1,000 series of possible 25 year investment returns, that were used to calculate 1,000 potential results for each of the gearing and super strategies. These results were sorted into quartiles for each strategy, as shown in the charts below:

Super Strategy

Gearing Strategy

It is clear that, particularly in the earlier years, there is considerably more variability associated with the gearing strategy than the super strategy.

Also, as the table below reveals, for each quartile, at the end of the 25 years the super strategy outperforms the gearing strategy. The compounding tax benefits of super are clear.

When investment risk is taken into account, it really makes you wonder why so many investors favour gearing over a salary sacrifice strategy.

Is superannuation just too boring?

Superannuation continues to offer a sound, tax effective strategy that all investors, including those some way from expected retirement, should not ignore. It may not provide the same level of excitement as holding a geared exposure, but investing should not be confused with entertainment.

Many younger investors opt for a gearing strategy because it provides a more immediate opportunity to see some significant results. Unfortunately, they may be adverse. If you’re a smart investor and prepared to be patient, the rewards of committing to a long term super strategy are likely to leave you in much better shape.

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Borrowing to Invest or Super? is a post from: Wealth Foundations Blog

Share and property investments are risky …

Most people understand that the returns of growth investments (i.e. shares and property) fluctuate considerably. If they didn’t prior to the Global Financial Crisis, they most certainly have a better grasp of that now.

But most don’t really have a good understanding of the potential range of variation of returns, without anything particularly unusual happening. And nor do they appreciate how dramatically the pattern of returns can affect long term wealth outcomes.

We use the Australian share market experience of the 25 years to December 2009 to shed some light.

The road to wealth is rocky …

The chart below that shows the growth of a $1 invested in the Australian share market (as represented by the S&P/ASX300) from December 1984 to December 2009.

While the average return over the 25 year period was 8.30% p.a. after inflation, growth fluctuated considerably around the dashed line. This line represents what would have occurred if the share market rose at a steady 8.30% each year.

To highlight how different to a nice steady path the actual experience was, the following chart shows the pattern of monthly returns:

The returns appear almost random, with some very large fluctuations around the average. The chart below plots these monthly returns on a bar chart or histogram to identify how they are clustered.

It reveals that they are distributed in an approximately bell shaped (or “normal”) pattern, as represented by the red line. Of course, there are some clear and very significant divergences from normality, with the October 1987 “crash” accounting for the outlier that sits at (-)42%.

But if the assumption is made that the returns are distributed as suggested by the red line, then standard deviation (“SD”) is a measure of their variation. At 4.82% a month, it implies that in any month returns had a 68% chance of lying between (-)4.0% and (+)5.6%. It also says that there was a 32% chance that the returns could be outside what is already a broad range.

So, share market returns are extremely volatile and have no apparent short term pattern i.e. essentially random.

A message to take from this is that in trying to predict future investment returns, the past is highly unlikely to provide any guide to the future! Even if you knew for certain that the returns came from the distribution represented by the red line in the chart above.

To show this, the charts below show two groups of ten possible 25 year share market futures that have been randomly generated from the same distribution that roughly describes Australian share market returns for the period from 1984-2009. These “futures” are compared with the 1984-2009 actual.

Ten possible futures …

… and ten more

The “futures” vary from significantly above to significantly below the past. They suggest virtually anything can and will happen.

However, to provide a better feel for the range of potential outcomes, we generated a 1,000 possible 25 year “futures” (or simulations) by randomly selecting annual returns from the normal curve shown above. The results are presented in the following chart:

It indicates that 5% of the simulated growth paths exceeded the “95th Percentile”, the green line, that itself was much higher than the actual experience of 1984-2009.

The final year outcome of the “median” or middle simulation, indicated by the purple line, was approximately consistent with the 1984-2009 actual experience.

Finally, 5% of the simulations were worse than the already nearly flat “5th Percentile”, represented by the orange line. It indicates the possibility of almost zero real growth in the share market for 25 years.

This may sound unrealistic. But the actual experience of the Japanese stock market has been much worse over the past 20 years, while the US stock market (i.e. S&P500), as at 31 December 2009, was still 30% below its March 2000 peak.

So wealth management is, perhaps, riskier than you thought …

Some key messages for wealth management that emerge include:

• accurately forecasting investment returns over an extended period is an impossible task;

• even if you could correctly predict the average return for that period, there are an infinite
  number of paths consistent with that average. Depending on the timing of your cash flows, your wealth outcomes could vary dramatically; and

• the pattern of past investment returns is unlikely to be much of a guide to future investment returns.

How can you plan in a world of such uncertainty i.e. the real world?

It sounds like your wealth position at some distant point in the future is essentially a lottery. Well, to a large extent it is, but there is a lot you can do to ensure that, despite the uncertainties, you give yourself the best chance of achieving your lifestyle objectives.

This article is an edited excerpt of Chapter 6 from our eBook, “Wealth Management: A risky business”. Sign up to obtain a free copy of the eBook plus monthly notification of articles recently posted to our “Smart Decisions Blog”.

Wealth Management: a risky business is a post from: Wealth Foundations Blog

Knowledge of investments isn’t everything

The availability of investment news and information has been increasing over time. This has led to an improvement in most people’s understanding of general investment concepts. It has created the opportunity for many to choose to manage their own financial affairs.

Knowing “where” to invest your money is an important part of the financial management equation. However, by itself, it’s far from comprehensive in terms of an investment strategy.

Consider the Storm Financial model of advice.

They used an eminently sensible and highly diversified investment approach for managing the underlying investments for their clients . Their investment strategy at this level was not the cause of the problems their clients would eventually experience. Simply knowing “where” to invest their clients’ funds was not enough to save their clients from financial disaster.

They failed to adequately address:

• The size of the investment exposure relative to their client’s lifetime capital accumulation amount (i.e. the question of  “how much” to invest), and

• How to manage the entry risk for their clients (i.e. the question of “when” to invest).

This part of their investment strategy was not only grossly naïve, it failed to adequately address the personal circumstances of each investor.

The strategic decisions they applied seemed to be based on:

1. “how much?” = as much you can borrow, and
2. “when?” = as soon as possible.

Apparently, this strategy was applied regardless of whether the client was a young accumulator or an elderly retiree.

How personalised is your investment strategy?

Many investors confuse personalisation of an investment strategy with choices at the specific investment level (e.g. I prefer BHP over Rio Tinto, or Australian Shares over International Shares). While this is a form of personalisation, it generally doesn’t add any long term (risk adjusted) value. In fact, personalisation at this level generally has a long term cost.

It may help to retain a client though, or convince a DIY investor to continue with their approach over other (more generic) alternatives.

True personalisation of an investment strategy is at the broader level of managing investment risk exposure over time. Arguably, this will have a much greater impact on your long term wealth than a strategy that focuses purely on your specific investments.

The “default” investment strategy

The natural investment strategy for most households is driven by the availability and timing of surplus cash.

Generally, households tend to generate more savings in the latter years of their working lives than the earlier years. It is not uncommon for households to invest over ¾ of their lifetime capital accumulation within 10 years of retirement. In the years prior to this, surpluses are used to reduce mortgages, fund school fees and buy lifestyle assets such as cars, boats, renovations, etc.

The dilemma for many who unwittingly apply this “default” strategy is that they acquire most of their investment exposure over a relatively short investment horizon. If these acquisitions happened to be at the end of a cyclical bull market, it could have quite catastrophic implications.

On the other hand, if you were lucky enough for your pre-retirement years to coincide with a cyclical bear market, you could end up acquiring a lot more market exposure than you would have under more optimistic conditions. The challenge for these investors is to recognise their good fortune. Many fail to do this and shy away from investing during declining markets.

Your investment strategy shouldn’t rely on luck

An investment strategy that may not differentiate at the specific investment level but sets a clear and personalised strategy for managing your investment exposure over time is much better than one that differentiates at the specific investment level but ignores the bigger picture.

A smart investment strategy considers much more than the investment of your current capital. It takes into account your projected savings capacity, the timing of these savings and your risk parameters to build a strategy that reduces the element of luck and focuses on giving you the best chance of achieving your objectives.

While this approach requires more effort (and knowledge), the payoff of a personalised investment strategy is to shift the odds in your favour.

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Is your Investment Strategy personalised? is a post from: Wealth Foundations Blog

The arguments in favour of residential property investment appear overwhelming

Housing prices remained reasonably firm through the worst of the “Global Financial Crisis” and have risen steadily over recent months. Many do-it-yourself investors, badly bruised by the battering taken by domestic and international sharemarkets, are seeing investment in residential property as a “safe” investment alternative.

The arguments in favour of residential property investment appear overwhelming and include:

• Capital city housing prices have gone up by about 10% since the start of 2008. Over the same period, the Australian share market fell approximately 20%, reflecting a 46% fall in the 14 months to February 2009, followed by 47% rise in the following 12 months. The conclusion being drawn is that residential property is not subject to the negative volatility of share markets;

• There is an apparently clear gap between the demand for and supply of residences, driven by immigration and natural population growth, with the estimated shortfall running at the rate of 30,000 p.a. The implication appears to be that this must lead to further increases in both rental yields and property prices;

• Residential property investment offers attractive tax “breaks”, with depreciation and any borrowing costs deductible against other income and capital gains taxed at a discounted rate. These “breaks” are viewed as benefits peculiar to property investment;

• It is easier to borrow against property than shares and without the need to meet margin calls if values fall. As a result, you can purchase more property than shares using borrowed funds. Clearly, this is a very good thing if you believe that residential property only goes up in value; and

• Last, but not least, you can touch and feel your property investment. Share investment is more anonymous, apparently more complex and less transparent.

The case for residential property investment is flawed

Given our investment philosophy, we don’t believe any of the above arguments stand up to scrutiny. Considering them in turn:

• Too many investors fail to understand that the oft quoted statement “past performance is not necessarily indicative of future performance” means exactly what is says and should be taken very seriously. Residential prices can, and do, fall heavily – the recent US and UK experience is evidence of that. The Australian residential property market is not somehow immune from waves of irrational exuberance and the potential for savage falls;

• The apparent gap between residential demand and supply is hardly a secret known only to property insiders – it is common market wisdom. While residential property markets may not “work” as well as transparent and liquid share, foreign exchange and debt markets, it seems to us that something that everyone already knows is more an explanation of why property prices are where they are rather than a driver of future price rises;

• The tax “breaks” for residential property investment are not, in our view, either “breaks” or special incentives restricted to property. For example, property investors are allowed to claim a tax deduction for depreciation, not as an undeserved benefit, but because structures do deteriorate and fixtures and fittings do wear out. Value is diminished and, as such, depreciation is a legitimate business expense. It is offset by a reduction in the cost base of the property and an increase in any capital gain, for tax purposes. The fact that capital gains are treated more favourably than income for tax purposes is a potential “break” but it is not limited to property;

• The ability to borrow more for investment in property than shares means it is easier to take on increased risk. However, most investors in residential property only focus on the opportunity borrowing provides for higher returns. So there is a tendency to “overborrow” and rely on the sale of the underlying property rather than future cash flow to repay debt. Should property values fall, the chances for financial ruin are correspondingly increased; and

• The emotional benefit of being able to “touch and feel” a property investment rates very low on our list of requirements for a sound investment. This tangible attribute implies a poorly diversified investment (i.e. a big bet on a single asset in a specific location) and hands on management. Most of our clients find their time better spent focusing on what they do well and/or love rather than actively looking after investments in which they have little expertise and/or interest.

Residential property investment is not the panacea

So, we don’t think residential property is the “holy grail” of investment, offering the opportunity for high returns with low or no risk.

Higher returns always require taking higher risk. But higher risk does not imply higher returns. And, often, it is when risk is least apparent or most underrated that prices become overdone, setting the scene for potential disaster should an unexpected event occur to upset the conventional “wisdom”.

The way we see it, a large, highly concentrated holding of any growth asset (i.e. property or share) is always high and avoidable risk. Borrowing to fund the purchase of that asset only compounds the risk.

We believe that the following recent comment from the Governor of the Reserve Bank, Mr Glenn Stevens, is a very timely warning to the increasing numbers of investors that are thinking residential property is a “no brainer”:

“It’s a mistake to assume a riskless, easy and guaranteed way to prosperity is just to leverage to property.”

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Is residential property a good investment? is a post from: Wealth Foundations Blog

How good is your crystal ball?

We’ve just been through (arguably) the worst share market downturn since 1929. We’ve also experienced a recovery that few predicted was possible at the start of 2009. Why were we not able to predict these events earlier and with more precision?

You may think it’s because you don’t have access to the information that the experts have. Yet most of the experts find successful predicting just as tough. While it was hard to ignore some of the apocalyptic predictions that were being thrown around during the depths of the downturn, acting on them would have proved very costly.

So, which predictions do you follow and which do you ignore? Or is there another way to manage your financial affairs.

Are you confusing skill with luck?

Most of us love to predict. We have an in-built addiction to prediction and a desire to look for patterns (even when none exist). When told that the outcomes of an event are random (e.g. a coin toss), we still try to identify patterns. It means that we are prone to fooling ourselves into thinking that randomness is not random. We confuse outcomes of chance for outcomes of skill.

While you may enjoy this behaviour, it does have a price. You need to work out if the enjoyment is worth the cost.

Consider the following:

1) Not everyone’s predictions can be right

The purpose of predicting is to try and out perform the market. Yet, few appreciate that it is impossible for everyone to beat the market.

This makes perfect sense if you consider that for every buyer there is a seller – all investors cannot be buyers (or sellers).

The return of the market represents the average return of all investors. In order to beat the market you have to perform better than the average return of all investors. Obviously, we can’t all beat the average.

This does not stop us from believing otherwise – another human frailty seemingly linked to our over optimistic perception of ourselves relative to others.

A study that required drivers to rank their own safety and driving skill relative to others in the group found that 76% considered themselves as safer than the driver with median safety.

And 65% considered themselves more skilful than the driver with median skill.

Is your ability to predict better than that of the average investor?

Chances are that you will perceive it to be so. Reality, however, suggests that your odds of beating the average are no better than 1 in 2.

2) Prediction has a cost

Compared to the investor that does not predict (or at least ignores their predictions), the investor who acts on their predictions will inevitably trade more. The cost of this activity (e.g. transaction costs, capital gain taxes, etc) reduces their odds of beating the average to less than 1 in 2.

Most serious investors would consider gambling at a casino, where the odds on offer are lower than those available by chance, to be a foolish investment strategy.

3) The market is a complex and adaptive system

Investment markets are far more complex than most people accept. Recent research has recognised them as Complex Adaptive Systems. These are systems in which the agents (who interact with the system) are also the components of the system. In other words, we as investors (agents) interact with the market (system) which then provides feedback to us and affects our behaviour. A simple example of this concept is the Story of the Red Indians.

The market is also adaptive, meaning that it has the capacity to change and learn from experience. While it is linked to the economic environment, it also forms part of that environment. As economic conditions change, the market changes. And, because it is also part of the economic environment, as the market changes, economic conditions change. This forms an endless loop which makes it extremely difficult to directly attribute cause and effect.

It leads to outcomes that are far more unpredictable than we would like them to be. Outcomes simply emerge without any apparent cause. For example, a termite hill is an amazing piece of architecture with a maze of interconnecting passages, caverns and ventilation tunnels that just emerges as a result of the termites following a few simple local rules. There is no grand plan for its design.

As the participants increase the complexity of their systems for analysing and assessing investment markets, the markets add even further layers of complexity and adaptive behaviour. This makes reliable prediction an extremely difficult, if not impossible, task.

Is there a substitute for forecasting?

You can still make intelligent financial choices that put the odds in your favour, without the need to know what the future holds. Letting go of the need to forecast opens up opportunities to add value through tax and cost savings and capital management strategies that offer a much higher probability of upside.

This all helps to improve your chances of achieving your long term objectives. The biggest hurdle is to overcome an in-built addiction to predict that offers no, or even negative, expected return.

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Forecasting the Market – Skill or Luck? is a post from: Wealth Foundations Blog

If you accept the often repeated warning that past investment returns do not provide a guide to future performance, you would be smart enough to not select a fund manager based simply on their recent results.

But what if you knew for certain (which you couldn’t) that a particular investment manager would return 1% p.a. above their relevant market indicator, before investment costs and taxes, for the next 10 years. Would you select that manager in preference to one that guaranteed you the market return? As we demonstrate, not necessarily.

Your objective as an investor should be to maximise your investment returns after-tax, costs and inflation for the amount of risk you accept i.e. your net risk adjusted return. In this article, we will focus on the importance of taxes and investment costs (e.g. fund manager fees, transaction costs). We have discussed the risk issue extensively in our “Foundations of Financial Economics” articles and, excluding inflation indexed bonds, there is little an individual investor can do, directly, to take account of inflation.

Taxes and investment costs can severely reduce the amount of money that ends up in investors’ pockets. Investment managers that are inefficient in the management of these components of your net risk adjusted return need to generate significant, reliable pre-tax and cost outperformance to compensate.

How tax structure, investment costs and the composition of investment returns interact

To examine how taxes and investment costs affect net investment returns, we assume an investment earns a before-tax, inflation and costs return or gross return of 9.2% p.a., for ten years. This happens to equal the return of the relevant market indicator for that type of investment i.e. it is “the market” return.

With inflation assumed at 4% p.a., an after inflation gross return of 5% p.a. is implied. Over ten years, $1,000 would grow to $1,629 in today’s dollars. We will call this “gross real wealth”. As we shall demonstrate, taxes and investment costs eat into gross real wealth to varying degrees.

As discussed in “Ownership of family wealth”, the amount of tax payable will be driven by who owns the investment. We look at four situations:

• A top marginal tax rate individual, paying 46.5% tax on income and 23.25% on capital gains;

• A company, paying 30% tax on both income and capital;

• A super fund, in the accumulation phase, paying 15% tax on income and 10% on capital gains; and

• A super fund, in the pension phase, paying 0% tax on both income and capital.

Given the differences between taxes paid on income and capital by ownership structure, the amount of tax payable will also depend on how the total pre-tax return on the investment is divided between ongoing income distributions and capital growth. We consider two cases: 35% and 65% of total return distributed annually as income, with the rest as capital growth.

And, finally, we look at two investment management costs’ scenarios: a “low cost” investment manager, at 0.50% p.a., and a “high cost” investment manager, at 1.50% p.a.

The table below shows the growth in the $1,000 (after allowance for investment costs, tax and inflation) over ten years for each of the identified scenarios:

Growth of $1,000: By structure, income distribution percentage and fees

To highlight the impact of tax structure, the composition of returns and investment costs on your wealth, the following table shows end wealth for each of the above scenarios as a percentage of gross real wealth, of $1,629:

Percentage of Gross Real Wealth: By structure, income distribution percentage and fees

Clearly, investment costs and taxes hurt. A high income distributing, high cost investment approach must obtain a significantly higher pre-tax gross return than a low income distributing, low cost approach to provide the same net return. And the amount of outperformance required will depend on ownership structure.

The table below shows the implied amount of outperformance for a high income distribution, high cost investment approach compared with low income distribution, low cost approach, for each structure:

Taxes and costs matter, greatly

The moral of the story is that to justify investor consideration investment managers charging high fees and making large ongoing taxable income distributions (usually because they actively trade their investment portfolios) must be expected to significantly outperform the market, before taxes and fees. And the less tax effective the investment ownership structure, the greater that outperformance needs to be.

The decision a potential investor must make is how likely is that degree of outperformance, over sustained periods of time. And allowance must also be made for the reality that market outperformance also requires taking greater than market risk.

Unfortunately, while attempts to choose superior performing investment managers could result in above market gross returns, they could just as easily lead to less than market returns, and with higher costs and more tax!

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Taxes, investment costs and investment returns is a post from: Wealth Foundations Blog

Rent is the price of housing accommodation

The home building industry often promotes to potential young home buyers that rent money is “dead money” i.e. money down the drain. It encourages them to stop paying rent and, instead, use the money to pay off the mortgage on their own new home.

I became very aware of the power of this self serving message when my 24 year old daughter proclaimed that she wanted to buy her own property as soon as possible, as rent was “just dead money”. Although impressed by her determination to take on such an obligation, I couldn’t resist the opportunity to give a basic economics lesson.

The reality is that rent is not dead money but the cost of purchasing housing accommodation. It is essentially the same as paying for a hotel room for an overnight stay or for a two week vacation in a luxury holiday resort.

We all pay the cost of housing accommodation, whether we rent from a third party or we own our home. And this is the case, regardless of whether or not we have a mortgage.

What is the real cost of home ownership?

For the home owner, an obvious cost of housing accommodation is what they could earn by renting their property i.e. it is the “notional rent”. This income foregone is a real cost. When viewed in this light, many are unwittingly “paying” a large amount for housing accommodation.

For example, the family with the $5 million residence is probably “paying” (i.e. foregoing) about $150,000 p.a. or roughly $3,000 a week in “notional rent”. Often, this notional rent is a very high percentage of total ongoing expenditure. And much greater than many home owners would be prepared to pay to rent a property from a third party, assuming they were to sell their home.

But notional rent is not the true cost of home ownership. The true cost is the best alternative you forego by committing funds to a home purchase i.e. the opportunity cost.

And this cost can be substantial. It explains why large supermarket chains and department stores generally rent/lease properties rather than own them. They consider they will get a better return by committing financial resources to the business of retailing rather than property ownership. And you don’t hear savvy investors suggesting that the rent Woolworths or David Jones pay to Westfield and others is “dead money”.

For many young people, home ownership may represent a poor alternative for their scarce financial resources. They may be better off at this stage of their lives committing funds to a business venture or maximising their career options by maintaining total flexibility with regard to where they live. Home purchase is a major commitment that may stifle the willingness to explore potentially higher risk but higher return opportunities.

Home purchase as forced saving

So rent money is not “dead money”. It’s the price you pay for something of value i.e. housing accommodation. And home purchase may not be the best use of a young person’s scarce financial resources.

Yet many baby boomer parents are encouraging their now adult children to get into the property market as soon as they can. They feel it worked well for them and proved a great “investment”, with the value of property always seemingly going up.

In our view, this thinking leaves a lot to be desired. A satisfactory outcome doesn’t mean the original decision was sound. The conclusions drawn by the baby boomers warrant some qualification:

• A home purchase is primarily a lifestyle choice. It doesn’t exhibit the characteristics of what we think is good investing practice;

• a major reason home purchase worked so well for baby boomers is that high inflation helped to ease mortgage pressure; and

• borrowing to purchase a home is a form of forced saving. Money that might otherwise have been totally allocated to consumption, with nothing to show for it twenty years later, was used to repay mortgage debt. As a result, the baby boomers now have largely debt free homes that provide them with a sense of financial security that they would like their children to enjoy. But saving, rather than astute investment, was largely responsible for this desirable result.

 
Invalid clichés and dubious logic do not make for sound decision making, particularly when the decision is regarding such a major obligation as a home. Ideally, the home purchase option needs to be rigorously compared with alternative uses of limited financial resources.

Of course, for a young person who does not have great financial discipline and/or can’t identify better alternative uses for their funds, then borrowing to buy a home, with its inherent forced saving, may be a good choice. But the phrase “rent money is dead money” and its implication that renting never makes economic sense are dangerously misleading.

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Is Rent Money, “Dead Money”? is a post from: Wealth Foundations Blog