Statistics shows that a high income does not mean high net worth

In our previous article, “Household income and wealth in Australia”, we examined the progress toward financial independence being made by the wealthiest 20% of Australian households, with wealth measured alternatively by household net worth and household gross income. We found that the net worth measure of wealth was a better indicator of current financial independence than was household gross income.

The official statistics [1] on which our analysis was based clearly reveal that a high income does not imply high net worth. In fact, they indicate that only about 34% of households that rank in the top 10% by gross household income also rank in the top 10% by household net worth.

This article examines some key differences in the characteristics of the wealthiest 20% (i.e. the top quintile), as measured by both household net worth and gross income, and also provides a comparison with the total population. It will provide some confirmation regarding what needs to happen to ensure that a high income converts to high net worth and, potentially, financial independence.

The top high net worth quintile looks different to the top high income quintile

The table below shows the average values of selected characteristics for the top quintiles by household net worth and gross household income, compared with the total population:

* Income from incorporated businesses, investment income

Consistent with what we would expect, the table shows that compared with households in the top net worth quintile, households in the top gross income quintile:

• are younger;

• earn most of their income from wages and salaries, with much less coming from businesses and investment income;

• are much more likely to have a home mortgage; and

• are more likely to rent (but much less so than the total population).

It is less obvious (to us, anyway) why a higher percentage of the top net worth quintile lives outside a capital city than does the top gross income quintile. Perhaps this reflects lower incomes outside the capital cities, more than offset by less expensive lifestyles, leading to higher net worth.

The statistics suggest that for high income households to also become high net worth households they need to place priority on building income sources that are not reliant on personal exertion (i.e. from wages and salaries) and reducing their mortgages. To see whether such behaviour is occurring, in the table below we examine identified major outlays as a percentage of income for the top net worth and gross income quintiles and the total population.

The table indicates that the highest gross income quintile looks much the same as the total population in terms of repaying debt and building up superannuation. There is no apparent emphasis on eliminating mortgages or focus on super as an alternative future income source. In contrast, the highest net worth quintile is allocating considerably more to superannuation (and life insurance), despite the fact that on average these households are already better placed on our measures of financial independence.

Early positive action is required to convert a high income to high net worth

A high income does not automatically convert to high net worth which itself is not a guarantee of financial independence. The analysis conducted in our previous article and above suggests that households in the top gross income quintile, on average:

• aren’t currently well positioned to achieve early financial independence; and

• don’t appear to be taking appropriate steps to give themselves the best chance of achieving it in the future.

As touched on in an earlier article, it may be that financial independence is not currently perceived as an objective worth pursuing, particularly by the highest 20% of income earning households for which the average age of the “reference” person is 45. It may be that for many the desirability of working by choice, rather than necessity, simply has not yet been considered.

Unfortunately, the longer the delay in taking a decision to pursue financial independence and implementing appropriate action, the more dramatic are the likely required changes in lifestyle expectations to achieve the objective.

[1] The relevant Australian Bureau of Statistics releases are:

• 6554.0, “Household Wealth and Wealth Distribution, Australia, 2009-10”, released 14 October 2011;
• 6523.0, “Household Income and Income Distribution, Australia, 2009-10”, released 30 August 2011; and
• 6530.0, “Household Expenditure Survey”, released 6 September 2011.

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A high income does not imply high wealth is a post from: Wealth Foundations Blog

Official statistics provide income and wealth insights

In the latter part of 2011, the Australian Bureau of Statistics released three publications [1] that together provide valuable insights regarding household income and wealth in Australia. The surveys supporting the statistical releases were conducted in 2009-10.

The publications provide the most comprehensive and up to date data, on a state and national basis, for a number of key financial planning and wealth management “progress indicators”. In this article, we will focus on how those in the top quintiles (i.e. top 20%) by household net worth and income are performing in terms of benchmarks we monitor for our clients. The aim is to assess the “financial health” of the nation’s wealthiest 20%.

In a follow-up article, we will examine some potentially interesting differences between those in the top quintile as measured by household income and by household net worth. In summary, high income does not always imply high net worth and the statistics offer some clues as to why this is the case.

How is the financial health of our wealthiest 20%?

Before concentrating on the financial health of the “Top 20%”, some context is obtained by looking at the distribution of household wealth and income for the entire population. The chart below shows the distribution of household net worth (i.e. total assets less liabilities) and reveals that a little over 80% of households has net worth less than $1 million.

Only an estimated 1% of the population (i.e. 88,300 households) has net worth in excess of $5 million, with just 0.3% having more than $10 million. We suspect avid consumers of financial and lifestyle media would be surprised by these findings. Significant wealth is much rarer than the marketers would have us believe.

The following chart shows the distribution of gross annual household income.

The median or middle gross household income is about $68,600 p.a. There are only an estimated 473,200 households (or 5.6% of the population) with gross incomes in excess of $208,000 p.a.

The table below shows the average values of selected key financial indicators for the top quintiles by household net worth and gross household income, compared with the total population:

*      Main residence, motor vehicles etc
**    Net Worth less Lifestyle Assets
***  Direct Property excludes own home
****Total Liabilities divided by Total Investment Assets (i.e. (7)/(6))

The data above is used to construct approximate measures of various financial planning metrics we focus on to assess our clients’ progress. They are provided in the table below, together with a minimum indicative benchmark measure we regard as consistent with financial independence (see “How does your “Personal Financial Scorecard” look?” for further explanation).

In terms of achievement of financial independence, the following observations are made:

• On average, too much of net worth is dedicated to lifestyle, rather than investment assets;

• Insufficient investment wealth is being held in the tax effective superannuation environment;

• Net investment wealth is well short of being able to sustain current expenditure indefinitely, with the retirement expenditure multiple looking woefully inadequate for those in the highest quintile by income and for the population in total; and

• Investment diversification is low – too much wealth is concentrated in relatively illiquid property holdings and businesses.

In summary, the financial affairs of our wealthiest 20% as measured by either net worth or income don’t, on average, appear to be well structured, while the position of the average Australian household is particularly poor. The Australian love affair with direct property, both as a lifestyle and investment asset, is evident with the average household holding almost 70% of net worth in this concentrated and illiquid form.

Wealth or income are not reliable measures of financial health

Averages hide a lot of information, but it is hard to escape the conclusion that even Australia’s wealthier households are not well positioned for financial independence. However, it is apparent that the top quintile as measured by net worth appears better placed than the top quintile as measured by gross income. Our next article will examine this issue more fully.

The message that we think should be taken from the above analysis is that looking like the average wealthy household is not the way to achieve financial independence. You need to structure yourself to meet your lifestyle objectives, rather than take guidance from somebody who you think looks like you.

[1]           The ABS releases are:

• 6554.0, “Household Wealth and Wealth Distribution, Australia, 2009-10”, released 14 October 2011;
• 6523.0, “Household Income and Income Distribution, Australia, 2009-10”, released 30 August 2011; and
• 6530.0, “Household Expenditure Survey”, released 6 September 2011.

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Household income and wealth in Australia is a post from: Wealth Foundations Blog

Do the “principles” still stack up?

When we started Wealth Foundations in late 2007, we had no idea just how troubled the world would become. At that time, we drew up what we regarded as twenty timeless principles for successful wealth management. They became the basis for our “Foundations” series.

It is interesting to revisit these “principles” four years later to see whether they still measure up or whether we built our foundations on shaky ground. Our assessment is that for those prepared to look beyond what’s happening now and are committed to building the financial future they want, the principles are as valid today as they were in 2007.

Our twenty principles of wealth management

Our twenty principles are restated below. Do they resonate with you?

1. Markets work – prices of investment assets incorporate all available information and can confidently be taken as “best guesses” of value. Don’t try to second-guess the market – benchmarks of asset class performance cannot be reliably beaten by stock picking or market timing. Any apparent outperformance reflects either luck and/or greater risk;
2. Risk and return are related – the level of risk you take will drive your investment returns. But if you need higher returns to achieve your financial objectives, do not just accept any type of increased risk. Take investment risk that has been reliably rewarded in the past and can be expected to be rewarded in the future. There are only five risks factors that meet these criteria;
3. Diversification is key – investment markets do not reward concentrated risk taking e.g. a share portfolio containing a dozen shares, a single investment property, an investment portfolio focused on a sector (e.g. resources) or country (e.g. Australia). Invest in broad based asset portfolios of every asset class where risk is rewarded over the long term in a strong and reliable manner;
4. Structure explains performance – Asset allocation (or risk exposure) is the primary driver of the returns of your investment portfolio. The most important investment decision you make is your allocation between defensive and growth assets. This depends on the interplay between your attitude to risk, your need for risk and your capacity for risk;
5. Learn to embrace uncertainty – rather than ignoring or avoiding the inevitable uncertainties that exist with managing your wealth, learn to accept and embrace uncertainty as a normal and ongoing reality of successful wealth management. It will make the journey more agreeable and rewarding;
6. Avoid focusing on the short term movements in your portfolio – over the long term, capitalism rewards risk-takers and share markets trend upwards. In the short term, however, markets move in a random fashion and randomness does not provide any useful feedback;
7. Look at the big picture – the broader the picture and the longer the time frame you incorporate into your wealth management decision making, the better decisions you are likely to make;
8. Avoid being over–confident – over–confidence is the cause of a high proportion of poor decisions, particularly when you think you know it all. A little humility and caution will improve your financial decision making;
9. Don’t look back – the best decisions are made with a forward looking attitude. Always aim to progress and avoid the unhelpful pressures that come with the thoughts of “what might have been”;
10. Learn to think independently of the crowd – following the crowd may be comfortable but is unlikely to help you achieve your objectives. Invest the time and effort to become clear about your lifelong objectives and take steps to move progressively towards their attainment (even if that means standing apart from the crowd);
11. Focus on what you can control – you can’t control outcomes, you can only influence or control inputs that drive those outcomes;
12. It’s about ends, not means – understand your primary objectives in making a decision and don’t be distracted by what may be secondary objectives or simply means to a desired end;
13. Value versus cost, investment versus expense – in making decisions, you should be looking for benefits that are in excess of outlays. The size of the outlay should be an input to rather than a determinant of a decision;
14. Information isn’t knowledge – don’t confuse information with knowledge (or, better still, wisdom) when making decisions. Too much of what masquerades as financial advice is simply information and may be counterproductive to making smart financial decisions;
15. Planning is a process not an event – effective planning is not a once off event. Circumstances change, requiring ongoing review of existing strategies against the back drop of objectives that also may be changing over time;
16. Avoid complexity – solutions are often more complex than they need to be. When it comes to your personal wealth management, if you cannot understand a proposed solution it is unlikely to be in your best interests;
17. Money is a means to an end, not an end in itself – the pursuit of wealth and its trappings for their own sake are unlikely to result in increased life satisfaction;
18. Acknowledge and celebrate progress – regularly review your achievements and progress. Take time to acknowledge and celebrate how far you’ve come. If you treat financial and lifestyle “success” as something that only happens when you have achieved all of your goals, you may find it elusive;
19. Accept your current circumstances – you are more likely to take clear and purposeful action when you are in a state of acceptance than one of avoidance; and
20. Implementation is critical – until a decision is acted upon it is only a good intention. Unless there is effective implementation, the best decision making and planning are a waste of time and effort.

Successful wealth management does not happen by chance

If you want to take control over what your financial future looks like, it is unlikely that you will be as successful as you could be without the necessary discipline, a well conceived strategy and sound principles to help you respond consistently to the myriad of decisions that must be made.

Our wealth management principles remain intact despite the turbulence of the past four years. We are confident that they will continue to provide a solid foundation to help build our clients’ desired financial futures.

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Principles of successful wealth management is a post from: Wealth Foundations Blog

Evidence triumphs over anecdote

If you’ve seen the movie “Moneyball”, (or read the book by Michael Lewis), you may have picked up on some similarities between the issues faced in managing a major league baseball team and those faced in managing investment wealth.

If you’re not familiar with the movie/book, it tells the story of Billy Beane, a professional baseball manager of the Oakland A’s, a low tier baseball team in the US major league. To overcome the financial power of the top tier teams, he adopts an approach that focuses on buying the attributes that win games (rather than buying the specific players he thinks will win games).

Rather than replace a high profile, big hitter with another equally expensive big hitter, Beane looked for other ways to replace him. The team didn’t necessarily need another big hitter, they needed to replace the (statistical) attributes that they had lost (e.g. the average number of times he got on base per game). By looking at player selection in this way he gave himself the freedom to build a winning baseball team without the restrictions imposed by traditional methods.

Subjective biases often conflict with objective evidence

We are all predisposed to behavioural biases that can get in the way of achieving the outcomes we want. These include:

• Our desire for conformity and following the crowd (regardless of how irrational that activity may be),
• Our natural inclination to take mental shortcuts, leading us to focus on subsets of available information, ignoring the whole. We generalise from personal experience and extrapolate (too readily) from recent events, and
• Our uncanny ability for self deception. We are far more likely to attribute positive outcomes to skill and negative outcomes to bad luck. This self deception results in a level of overconfidence that is unwarranted.

Beane takes on the established ways of the baseball scouts who have spent most of their lives in the pursuit of discovering the next super star. Their primary focus is on athleticism, hitting power and demeanour but also extends to upbringing, looks and even girlfriends. The decision by one scout to discard a player is driven by the rating of his girlfriend: – “She’s only a 6 – it’s a sign of low self confidence”. These subjective factors are all tossed around until some sort of consensus is achieved.

Beane knows the folly of this approach. He was once one of those “discovered super stars” who met all the criteria of the scouts. Yet, he never lived up to their high expectations. He knows their approach is littered with behavioural biases that cannot help his team.

He (or at least his assistant) has researched baseball history (statistics) and knows how many runs are needed to win enough games to play in the finals. His aim is not to buy players, it’s to buy runs. And, buying runs is cheaper than buying players.

The research found that “an extra point of on-base percentage was worth three times an extra point of slugging percentage. A player’s ability to get on base especially when it was in unspectacular ways tended to be dramatically underpriced in relation to other abilities.”

As you’d expect, Beane’s non-conformist approach ruffles feathers and leads to many fall outs with staff and players. Biases and beliefs are hard to shift.

“Moneyball” highlights a level of self deception amongst the scouts (and the general baseball community). They spend a lot of time “researching” their targets and insist they can tell the difference between hitters, yet “one absolutely cannot tell, by watching, the difference between a .300 hitter and a .275 hitter. The difference is one hit every two weeks”. Still, conformity wins out. This behaviour has been pervasive for decades.

Interestingly, Beane had no issue in divulging his approach to Lewis for the book. He did not see it would jeopardise his edge. He believed the behavioural irrationalities are so ingrained they will never disappear.

The “Moneyball” story has clear investment parallels. Stock brokers and investment pundits have the most intimate knowledge of their most prized stock tip, yet have no real evidence that it is not already overpriced. Many investors seek the comfort of blue chip shares. They look good and have great (apparent) prospects but if everyone else wants them they come at a pretty high price.

Value stocks on the other hand are out of favour. No one really wants them and consequently you can purchase them (relatively) cheaply. Sure, there’s more risk but if you hold a diversified exposure of value stocks, they’re more likely to outperform the blue chips.

Many investors would question the rationale of buying a company that has poor prospects? Viewed objectively, though, the higher risk prospect has a higher expected rate of return. Michelle Clayman illustrated this concept in 1987 when she compared “Excellent” companies, identified by the 1980s best seller, “In Search of Excellence”, with a selected group of companies regarded as “Unexcellent”. The comparative economic health measures that distinguish the companies are as shown below:

Despite appearing unattractive, in the five years that followed the publication of the book, the return on the shares of the Unexcellent companies exceeded that of the Excellent companies by a wide margin.

Do you want to buy quality players (excellent companies) or buy the most runs you can afford within your budget (maximise the return for your risk budget)?

Our greatest challenge is often us

In applying the observations of “Moneyball” to wealth management, it would appear that our greatest challenge to improving outcomes is in overcoming our behavioural biases.

Often we get caught up in the excitement of a share or financial product that has sound “pedigree” and great prospects. Yet, we miss the bigger picture of how it fits in to a lifetime plan. Further, many investment strategies miss the mark by focusing (almost exclusively) on high returns (i.e. big hitters) instead of on maximising the chances of achieving long term objectives (i.e. playing in the finals). And, above all, we lose faith in a well considered strategy far too easily (and, invariably, at the worst possible time).

If you haven’t seen the movie, we recommend it. We expect you’ll identify with some of the behavioural biases and see the parallels with applying a well researched plan and process for managing your wealth.

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Moneyball: a story of faith in an objective strategy is a post from: Wealth Foundations Blog

Clearly, financial independence isn’t important for everyone

“Financial independence” is achieved when you have sufficient net investment wealth to support your desired lifestyle indefinitely, without the need for earned income i.e. work is a choice, rather than a necessity. We have always regarded the achievement of financial independence as a financial planning objective that most would embrace.

However, separate conversations that I had last week with three mid-late fifty year old professionals (who aren’t currently Wealth Foundations’ clients) really made me think that perhaps we, and our clients, were living in an alternative universe. The three admitted that within the past six months they had each borrowed between one and two million dollars either to renovate their existing residence or partly finance the purchase of a new residence.

And, apparently, they felt reasonably comfortable doing so. Either their accountant and/or financial planner had assured them that they could service the debt. Or they took solace from the fact that many colleagues around their age were borrowing similar amounts for similar reasons.

While we don’t know their full circumstances, the fact that they needed to borrow indicates that they didn’t hold sufficient (liquid) investment wealth outside superannuation to finance their lifestyle purchases. It suggests that virtually all their wealth is now tied up in lifestyle assets, with little, or even negative, net investment wealth: the wealth that is required for financial independence. The $2 million borrower disclosed that apart from his (now beautiful) home, superannuation was his only other meaningful asset and that its value fell well short of the debt.

Financial independence may not be achievable

So, early financial independence clearly is not a priority for these three professionals. The likely reality is that they will never accumulate enough net investment wealth to be able to maintain the lifestyle they have become accustomed to. They will have to continue to work whether they like it or not!

To illustrate this, let’s assume a mid 50’s, high income, professional family has a household income of $1,000,000 p.a. in today’s dollars. Their affairs are structured to tax effectively split income, resulting in after-tax household income of $600,000 p.a.

They would like, at some stage in the future, to have accumulated sufficient investment wealth to be able to spend $250,000 p.a. indefinitely without the need to work – using our “rule of 25”, this implies a future target of $6.25 million in today’s dollars. After taking account of their superannuation and borrowings, their current net investment wealth is (-) $1 million i.e. they need to accumulate $7.25 million for financial independence.

Given their after-inflation, after-tax income of $600,000 p.a., the time it takes to achieve financial independence depends on:

• The return on investment wealth i.e. the “return”; and

• The amount of pre-tax income saved i.e. the “savings rate”.

The chart below shows the number of years required to accumulate $7.25 million for various returns [1.] and savings rates:

For example, focusing on a reasonable possibility, it would take almost 20 years to accumulate the desired amount of investment wealth at 10% p.a. and a savings rate of 25% (or $250,000 p.a.) [2]. A 55 year old would be 75 before financial independence is achieved!

While the reality is at age 75 the “rule of 25” is possibly too conservative, it is also unlikely that our three professionals would want to or be able to work as hard in their seventies as they are now. Earlier financial independence depends on them:

• saving more – something their current situation suggests does not come easily; and/or

• achieving higher investment returns for long periods. But even an improbable return of almost 16% p.a. only reduces the accumulation time by about 4 years.

Are you “planning to fail”?

Now it could be that each of the three professionals is expecting a large inheritance to save the day. But when the suggestion was made that their focus on consumption and lifestyle assets rather than investment assets was committing them to having to work a long time into the future, the common response was that if need be they could always “sell down”.

While their stories represent a very small (but random) sample of high income, mid-late 50’s professionals, the commonality of their financial strategies raises a potential dilemma. If a large percentage of lifestyle asset-rich baby boomers is relying on “cashing out” over the next 10-20 years to finance a lifestyle that previously depended on a high income, will the demand for all these high end properties be there at current prices (in today’s dollars).

And should the market be particularly poor when the baby boomer has to sell, the concentrated nature of residential property means that they cannot sell a little bit at a time. A significant “haircut” may be required in an illiquid market, necessitating a downward shift in lifestyle expectations at a time when they should be enjoying the fruits of their hard work.

The fact is that some people choose to live for today and hope the future will look after itself. Others don’t even think much about the future but benchmark their lifestyle against those that they consider to be in a similar situation.

And then there are those, like our clients, who proactively manage their current consumption to give themselves future choices and, ideally, financial independence. They would agree with Winston Churchill’s famous war time quote:

“He who fails to plan is planning to fail.”

[1.] The modelling is based on after-tax and after-inflation returns. To help understanding, the returns shown on the chart are adjusted to pre-tax and pre-inflation equivalents assuming a tax rate of 30% and inflation of 3% p.a.

[2.] Implies expenditure while working of $350,000 p.a.

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Financial Independence: a worthwhile financial planning objective? is a post from: Wealth Foundations Blog

Surely, it’s better to defer paying tax

It is not unusual for clients to have sizeable exposures to individual shares that they have held for long periods of time. We generally would encourage them to sell these holdings and invest the proceeds into highly diversified investments to reduce the risk of their portfolios, without a loss of expected return.

However, we often experience considerable resistance to this advice if sale of the shares would result in the crystallisation of significant capital gains and the obligation to pay capital gains tax. Clients reasonably ask “What’s the point of taking an unnecessary action that brings forward the payment of tax?”

The reality of many of these situations is that they offer the opportunity to employ the funds in a more tax effective manner. As a result, the client may end up better off in a cash flow sense as well as having a more highly diversified investment portfolio.

Superannuation is a super friendly tax environment

To illustrate the potential to be better off in a cash flow sense, we assume that a client (personally) holds a share that currently has an unrealised capital gain. It is also assumed that the client is on the top marginal tax rate (i.e. 46.5%) to age 60, after which the marginal tax rate falls to 31.5%. The alternatives considered are:

• Hold on to the share for 20 years and then sell; or

• sell now, pay the capital gains tax, and place the residual funds into superannuation as a non-concessional or after-tax contribution. The funds are assumed to be invested in a diversified share fund, with the same expected return characteristics as the individual share [1]. At age 60, the client transitions to the pension phase resulting in zero tax on both ongoing distributions and capital gains on any sale.

A decision to sell now will result in an immediate cash outflow in the form of capital gains tax, the amount depending on the size of the capital gain. But for the next 20 years the more tax effective superannuation environment will result in significantly higher after tax returns on the diversified investment held inside superannuation than on the share held outside superannuation.

The upfront tax payment can be thought of as an investment, with the ongoing difference in cash flows between the alternatives over the 20 years providing the return on that investment. The chart below shows that rate of return for various sizes of capital gain (as a percentage of the share’s current value) for the client under two scenarios i.e. a current age of 50 and a current age of 60.

It reveals that when the client is aged 50, there is a positive return from selling and reinvesting into super provided the capital gain is less than about 75% of the share’s value. For example, if the share comprises 50% capital gain (i.e. a share worth $100 that consists of $50 of capital gain would result in an $11.63 capital gains tax outflow on sale), the future cash flow benefit would provide an after-tax return of 12.8% p.a. on the tax outlay.

At lower levels of capital gain, the returns are significant. As the capital gain increases, the net outflow for tax payments means there are less funds available to benefit from the favourable superannuation tax environment.

There is a higher return at all levels of capital gain at age 60 compared with age 50 and a positive return, regardless of the size of the capital gain. The immediate move to a zero tax environment in super more than offsets the negative effect on return of a large upfront capital gains tax payment.

Tax should not drive investment decisions

So there is potential to have your “cake and eat it” i.e. a superior cash flow and a better diversified portfolio. However, each situation needs to be looked at based on individual circumstances and the best assumptions that can be made at the time.

But as a generalisation, we would always caution against letting tax concerns outweigh sound investment principles. While tax implications should always be considered, they should not drive investment decisions.

Large concentrated share holdings add significantly to portfolio risk and, over extended periods of time, are expected to underperform the total share market. Individual shares may fall heavily (and, potentially, to zero), even in markets that are buoyant.

As the past four years have shown, a reluctance to diversify and balance portfolios because of capital gains tax implications can result in significant wealth erosion and severely jeopardise financial plans. We do admit, however, that it takes a very disciplined investor to deliberately create a tax obligation in the quest for increased diversification. Potential cash flow benefits may make that decision somewhat easier.

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[1]  The return characteristics of the share are assumed to be a 4% p.a., fully franked dividend, with growth of 5% p.a.

You can be better off paying capital gains tax! is a post from: Wealth Foundations Blog

A tasteless ad that may be loose with the truth

The title of this article is the “headline” for an advertisement for the 2012 Jaguar XJ and XK that recently appeared in “The Sydney Morning Herald”. As though the headline wasn’t tacky enough, the copy goes on:

“While most luxury cars tell the world you have money, only a Jaguar lets it know you also have taste.”

At a driveaway price of “from $195,000”, taste certainly does not come cheap.

It is rare that an advertisement so directly links a luxury good with money and, by implication, wealth. Most only allude to a link between the purchase of luxury cars, clothes, watches, holidays etc and economic success.

But we expect few would argue with the proposition that marketers want you to believe that financially successfully people purchase luxury goods and if you want to be financially successful, you should too. They also want you to believe the converse: if you are not buying luxury goods, you could not possibly be financially successful.

However, if the research on the behaviours of US millionaires by Dr Thomas Stanley, author of “Stop Acting Rich … and Start Living Like a Real Millionaire” is applicable to Australia, the relationship between luxury good purchases and real financial wealth is, if anything, inverse i.e. the more luxury goods you purchase, the lower your net investment wealth is likely to be.

In particular, he notes that:

“It’s just not true that the rich drive expensive cars. The median price paid for motor vehicles among millionaires surveyed was $31,367. Truly rich people don’t drive BMWs; they drive Toyotas.

Stanley defines millionaires as those holding more than $1 million in net investment assets. The family home and other lifestyle assets are excluded from this measurement, as they are seen primarily as sources of consumption rather than avenues to true financial independence.

Prestige motor vehicles are a serious wealth drain

In a chapter of his book, called “The Road to Happiness”, Stanley examines in more detail the link between luxury car purchase and financial wealth. His conclusions are enough to drive the marketers to drink – the finest money can buy, of course.

He notes that in the US “86% of all prestige/luxury makes of motor vehicles are driven by nonmillionaires”. His conclusion is that a lot of prestige car purchasers are acting rich, rather than actually being rich.

He acknowledges that many prestige cars are purchased by those he calls the “glittering rich” (i.e. the super wealthy) and those on high incomes (who also may not be as wealthy as they appear and are described by Stanley as “income affluent”). But many more are pedalling hard to meet their kids’ school fees, their mortgage payments and the lease payments on their expensive motor vehicles, convinced that economic “success” is measured by the things you acquire rather than the size of your bank balance. These “aspirationals” don’t realise that 94% of real millionaires purchase their cars outright, rather than lease them!

The reality is that prestige motor vehicles are a significant drain on your wealth and an impediment to achieving true financial independence. For a client who wishes to acquire and maintain a $200,000 equivalent motor vehicle for the rest of their life, we would allow for an annual cost in today’s dollars of about $30,000 p.a., comprising:

• $20,000 for ongoing replacement;
• $2,500 for comprehensive insurance;
• $3,000 for petrol;
• $3,000 for servicing and other maintenance;
• $1,500 for other costs e.g. third party insurance, registration etc.

On the top marginal tax rate, this implies about $56,000 p.a. of pre-tax income must be dedicated to owning, maintaining and replacing the car on an ongoing basis. Alternatively, given our rule of thumb that it requires a capital sum of about 25 times a desired annual expenditure to maintain that expenditure indefinitely, the $200,000 motor vehicle implies a commitment of about $750,000 of your net investment wealth!

To justify allocating $750,000 of your wealth to such a prestige car requires you to either be very wealthy or place a low priority on achieving financial independence.

Resist the marketers’ hyperbole

The aim of marketing is to separate you from your hard earned, by coaxing you to respond to a need or want, either real or created. Luxury goods marketing aims to create the impression that by purchasing the “right” products, you will demonstrate that you are a “success” and/or possess excellent taste.

Unfortunately, most purchases of luxury goods are made in anticipation of becoming a financial success, rather than as a reward for it. While some short term satisfaction may result, the purchases come at the expense of progress in building real financial wealth.

If achieving financial independence is important to you, unless you are “glitteringly rich” it is critical that you resist the marketers’ hyperbole that you should spend $195,000 on a car to show the world that you have both money and taste!

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“For those with taste, not just money” is a post from: Wealth Foundations Blog

Gold as a safe haven

The allure of Gold, as a viable long term investment option, has shot to new heights in the past five years. While this is perhaps understandable given its status as a safe haven, should it be a fundamental component of an investment portfolio?

There is a lot of misunderstanding about gold, its role in the financial system and use within an investment portfolio. We aim to address some of these misunderstandings.

A Brief History of Gold

Gold first became a transferable form of money around 560 B.C. when gold coins (stamped with a seal) were used by merchants to simplify trade. The coins were valued according to their inherent gold content. In 1066, Great Britain developed the British pound (symbolising a pound of sterling silver) and other units of currency based on their inherent metal value. During this period, gold (and silver) represented the main means of exchange (i.e. money).

In 1792, the US established a bimetallic standard which required that every monetary unit in the United States was backed by either gold or silver. In 1913, the US Federal Reserve was created and issued promissory notes (the present day version of money) that guaranteed the notes would be redeemed for gold on demand. Under these arrangements, the money used in circulation simply represented the gold (and silver) held at the bank.

Gold coins were still in circulation in 1934 when the US government ceased their minting (under the Gold Reserve Act) and began to take them out of circulation. Currency notes were still backed by gold until 1971, when the US abandoned the gold standard and ceased to directly back the currency with gold reserves.

The fact is there probably isn’t enough gold in the world to cater for the monetary requirements of today. As the world’s population has grown, it has outstripped the rate of growth of gold deposits. So, whether we like it or not we have had to accept a monetary system that is no longer backed directly by gold. Each unit of currency is now backed by the issuing central banks, which continue to hold some gold as part of their reserves.

Gold as an investment

Some arguments for buying gold include:

• Its price is well below it’s all time inflation adjusted high;
• Anyone holding US dollars will be at the victim’s end of a grand Ponzi scheme;
• I want to hold gold in case society falls apart and paper money no longer has any value;
• Paper money/fiat currency is losing value as we speak while gold and silver are holding value;
• Gold has many uses and does not oxidize or form compounds. It is forever;
• Gold is the safest thing I can purchase because it’s a physical metal I can actually store;
• I’ve lost faith in the financial system, so I’m going back to gold;
• Precious metals have no counter party risk. You don’t have to depend on the assurances of others that they have value. They have intrinsic value whereas paper does not;
• Physical gold has a limited supply. It has only one way to go. Up.

Is the price of gold determined by its value as a raw material? Is it determined by its value as a hedge against inflation? Is it determined by its value as a hedge against the implosion of the monetary system?

There are so many different reasons for buying gold. Those buying it as a raw material may be prepared to pay a very different price to those buying it to protect against the implosion of the financial system. It seems that anyone that holds gold uses multiple arguments to justify its value and their prognostications about its future value.

The chart below shows the movement in the (USD) price of gold and silver over the past 5 years. With the benefit of hindsight, the time to buy gold was five years ago, but few had the foresight (or luck) to get this right.

Regardless of gold’s recent price performance, an investor’s aim should be to build a diversified portfolio of assets that have a reliable method for generating an expected return. For example, you buy shares because you expect to be rewarded as a result of the profit growth of the underlying businesses over the long term.

By way of contrast, including an allocation to currency (say US dollars) in an investment portfolio adds a risk exposure that has no long term expected (real) return. While its price will fluctuate (often with extreme volatility), it does not meet the requirements of a true investment.

Gold is an asset that behaves more like a currency i.e. it too has no expected (real) return. It does not produce an income stream that can be valued. As Warren Buffett explains:

 ”You could take all the gold that’s ever been mined, and it would fill a cube 67 feet in each direction. For what that’s worth at current gold prices, you could buy all – not some – all of the farmland in the United States. Plus, you could buy 10 Exxon Mobils, plus have $1 trillion of walking-around money. Or you could have a big cube of metal. Which would you take? Which is going to produce more value?”

It’s important to note that most investors with a diversified portfolio already have an indirect exposure to gold (and other commodities) via exposure to the companies that mine and market the commodity. The share price of these companies will be affected by commodity prices.

For those justifying the addition of gold to a portfolio as a safe haven investment, you need to be mindful that gold behaves in a far more erratic fashion than traditional safe haven investments such as cash and bonds. Because it’s so difficult to value (having no expected return), its price behaviour can be quite volatile (as seen below).

Investing is about value, speculating is about price

Gold has proved to be a bright light amongst the gloom of the past 4 years. It has certainly attracted a lot of attention and there are many passionate supporters of the shining metal. Yet “investing” in gold is far from the safe haven investment many purport it to be. At a fundamental level, you need to decide if you’re an investor or a speculator before you jump on the gold bandwagon. You can make money trading gold, but be clear – it’s a speculators’ game.

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The Allure of Gold is a post from: Wealth Foundations Blog

The real risk is running out of money

In turbulent and generally downbeat financial markets, like we have experienced since the end of 2007, there is natural tendency to become more cautious. To spend less, save more, pay-off debt and, particularly for those close to or in retirement, hold more investment wealth in defensive assets i.e. cash and fixed interest.

We may get a sense of comfort from knowing that the value of our investments cannot fall further and believe we have adopted a sensible, low risk investment strategy. And this is certainly true, if you think that investment risk is measured solely by the volatility of investment returns, pre inflation and tax.

But if the risk you are more concerned about is that you won’t be able to live the lifestyle you want or that your money might run out before you do, then high levels of defensiveness may be very risky.

Your lifestyle expectations and investment risk may not match

We have no idea of what the future will bring, so need to resort to the past to help illustrate the potential risk of letting your investment strategy be determined by an emotional response to volatile markets rather than by other more objective factors.

Below, we examine three portfolios, a 100% defensive portfolio, a balanced portfolio (i.e. 50% defensive/50% growth) and a 100% growth portfolio, using US data for the period December 1969 to December 2010:

Volatility of 7.3% for the defensive portfolio suggests that 68% of the annual returns varied between -3.8% and 10.8%. Note that the returns are after inflation. The comparable figures were -5.1% and 15.9% for the balanced portfolio and -11.5% and 25.9% for the growth portfolio.

The chart below, that is scaled on a log or proportional basis, shows the growth of a $1 for each portfolio over the period and reveals that:

• the growth portfolio achieved the highest accumulated value; but

• an investor would have needed to cope with extreme volatility to reap the rewards.

This history is useful in the sense that it shows that at least in the past investors have been rewarded for taking greater risk. But they needed to be patient and have nerves of steel, given the volatility of returns.

But even for a retiree with nerves of steel, the above analysis may not be very helpful. The reality is that the future is unlikely to look like the past and investment capital is not left untouched but is regularly rundown to meet living expenses.

However, if we are prepared to make the (admittedly heroic) assumption that future returns will come from the same distribution as those of the past (i.e. same expected (but not guaranteed) returns and volatilities), we can use a technique called Monte Carlo analysis to show for a typical retiree:

• a potential range of wealth outcomes; and

• the likelihood of running out of money

for various levels of desired future expenditure.

To illustrate, we assume a 65 year old retiree with an initial investment wealth of $2 million and a desire to spend $80,000 p.a. in today’s dollars (i.e. 4% drawdown of initial wealth) for the rest of his life. Using the expected returns and volatilities of the portfolios, we can simulate any number of potential wealth paths for each portfolio and the probability of running out of wealth at any particular future age.

The charts below show the range of wealth paths for the defensive and growth portfolios based on these assumptions and 1,000 simulations:

As is apparent, increased defensiveness narrows the range of possible wealth outcomes, at the expense of potentially building a significantly larger estate. For this scenario, the probability of consuming all wealth by age 95 is 8.8% for the defensive portfolio and 19.1% for the growth portfolio, suggesting maximum defensiveness is a virtue. But the probability of running out of wealth at age 95 for the balanced portfolio is an even lower 5.1%.

The table below shows the probability of running out of wealth at age 95 for the three portfolios for a range of desired expenditure (initial drawdown) levels:

Probability (Wealth)=0 at age 95

The analysis suggests that as lifestyle expectations rise (i.e. desired expenditure increases), the defensive portfolio becomes increasingly risky and the growth portfolio relatively less risky, as measured by the likelihood of running out of money.

Low investment risk dictates relatively modest lifestyle expectations

While the above discussion is based on a number of assumptions, there are some conclusions that we think hold up under a broad range of circumstances if the risk you are most concerned about is that of consuming all your wealth. These include:

• a highly defensive portfolio only makes sense only if you have modest lifestyle expectations relative to your investment wealth and the size of your estate is not a major issue;

• the higher your lifestyle expectations relative to your wealth, the more growth oriented your portfolio needs to be;

• your growth allocation should not exceed your tolerance for risk, to reduce the possibility that your emotions drive you to abandon a well formulated investment strategy when growth assets perform poorly; and

• the preferred way to adjust to prolonged market downturns is to reduce expenditure expectations, rather than to increase defensiveness.

And these conclusions are made before taking account of the relatively unfavourable tax treatment that applies to defensive assets compared with growth assets.

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Is a 100% defensive portfolio low risk? is a post from: Wealth Foundations Blog

Just because you can doesn’t mean your should

Borrowing to buy property within a Self Managed Super Fund (SMSF) has been promoted by many within the advice industry as an exclusive opportunity you should seriously consider. And, while there can be occasions where this strategy makes sense, as a general rule the fundamentals just don’t stack up.

Back in 2007, the Government opened the door for SMSFs to borrow. The change was driven by the popularity of investing in instalment warrants (such as Telstra’s T3 offer). These investments had an element of gearing which created some confusion under the no borrowing restrictions of the Superannuation Industry (Supervision) Act. To over come this, the Government decided to remove the borrowing restriction.

This led to the development of borrowing arrangements to purchase property within an SMSF, which in turn has led to a surge in the supply of advice promoting this sort of arrangement. But a closer look at these arrangements reveals that there just aren’t too many structural advantages to borrowing within super.

Claimed benefits of borrowing within super often a “sleight of hand”

It seems that many of the (freely available) tax benefits of super are being claimed in order to make these financing arrangements look better than they really are. Take, for example, the recommendation to use concessional (pre-tax) contributions to fund the interest payments on the loan. Using this idea, you can argue that you get a 46.5% tax deduction on the loan interest expense.

Here’s how it works:

The super fund borrows $320,000 at an annual interest cost of $25,000 (or 7.8%). This is funded via a salary sacrifice arrangement that ends up costing only $13,375 in foregone (after tax) income. That’s an effective (after tax) rate of 4.2% per annum (a deduction of 46.5% on the gross interest amount).

You may argue that this is a smart strategy.  But it relies on the benefit of the salary sacrifice arrangement – a benefit that is freely available without the need to enter a borrowing arrangement. The dubious logic serves to hide the reality that borrowing by a low tax paying entity is an undeniable negative.

When stripped of the “sleight of hand” of claiming the benefit of salary sacrifice as a benefit of borrowing, the actual after tax interest cost to the super fund is $21,250 (or 6.6%¹) per annum. That’s more than 50% higher than the after tax cost if borrowed directly by the contributor. This structural disadvantage increases the breakeven hurdle return required from the underlying investment.

Many of these borrowing strategies involve internal gearing arrangements. That is, arrangements where one family member becomes the borrower and lends the funds to the super fund. It looks something like this:

In this case, the family group carries an after tax cost of $4,125 (or 1.3%) per annum. Arbitrage opportunities can arise when you shift (deductible) expenses from a low tax payer to a higher tax payer, but in this case the arrangement is the other way around.

Of course, the logic used by the promoters of these arrangements is that the income and growth of the (purchased) asset will be taxed at a much lower rate (of between 0% – 15%). Therefore, put as many assets as possible into super (via debt funding). Yet this argument ignores the ability of the spouse (in this case) to contribute the $320,000 to super (rather than lend it).

Shifting assets into super is (generally) a smart strategy for reducing your lifelong tax burden. However, doing it by way of borrowing is significantly inferior to simply contributing the capital via concessional and non-concessional contributions.

But, what about the investor who doesn’t have the capital available to contribute and purchase the (property) asset outright? Is a super borrowing arrangement a smart strategy for them?

It really depends on whether they want to ramp up their investment risk. This has more to do with their tolerance, capacity and need for taking investment risk than any structural (dis)advantage of borrowing in super. The strategy could pay off but (as with all gearing arrangements) the success has more to do with the performance of the underlying asset than the benefits of the financing arrangement.

Borrowing to invest in Super: complexity that comes at a cost

Borrowing to invest in super can be a smart strategy in some limited circumstances. However, you need to make your decision with your eyes open, knowing that it carries an inherent (ongoing) cost. This cost can only be overcome by the strong growth of the underlying investment.

The increase in the supply of advice for these arrangements seems to be driven by flawed logic (that lays claim to benefits that are independent of the arrangement). These benefits can be accessed without having to undertake a borrowing arrangement.

Implementing these borrowing strategies is very complex and requires specific expertise. The promoters of these arrangements are willing to sell you their expertise (and, perhaps, for another fee, find you an appropriate property). We just think they’ve lost sight of the fact that the arrangements are inherently inefficient and rely on booming (property) asset prices.

1.That is, the gross interest cost (7.8%) less the tax benefit (7.8% x 15% = 1.2%), which results in an after tax interest cost of 6.6% per annum.

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Borrowing to buy property within Super: Buyer Beware! is a post from: Wealth Foundations Blog