I wrote a blog in February 2020 highlighting the first phase of government mandated changes to income protection insurance products. The second phase of changes were implemented at the beginning of this month, and they are very significant. This blog discusses these important changes and how they may affect you.BackgroundIn December 2019, the insurance industry’s regulator (APRA), released a report outlining a number of compulsory changes that it mandated for income protection insurance products. Income protection insurance pays you a benefit if you cannot work due to accident or illness (it does not protect you from involuntary unemployment).These changes were deemed necessary because insurance companies were losing literally billions of dollars on these products i.e. cost of paying benefits far exceeded premium revenue. However, no insurer wanted to make the first move to stem the losses. Fearing that insurance companies may eventually exit the Australian market (if no action was taken), the regulator stepped in and mandated changes to make products more sustainable.There were two main issues that caused these products to be so unprofitable:1. An inability for insurance companies to change terms to accommodate new risks. Mental health is a good example. Mental health claims were immaterial when policy terms were written 20 years ago. However, today, claims due to mental health are more substantial.2. Long term benefits are very costly. If a 30-year-old claims on a policy and is never able to return to work, the insurer could be paying a benefit for the next 35 years. That is very costly. Therefore, it is important that policies only provide for genuine claims. Unfortunately, for the insurers, some policy terms are so generous that they sometimes act as a disincentive to cease being on-claim. This exacerbates losses.Summary of the changes made this monthAll insurers launched new product suites at the beginning of this month (existing products are no longer available). These new products reflected four important changes:1. The amount of income that can be insured has reduced from 75% to 70% of your gross income. Replacing less of your pre-disability income gives you a greater incentive to return to employment as soon as possible.2. The total benefit paid within the first 6 months of claim cannot exceed 90% of your pre-disability income. Many pre-October 2021 products offered ancillary benefits such as lump sum payments for specified conditions and rehabilitation benefits.3. Pre-disability income is based on your actual personal exertion income received the 12 months prior to becoming incapacitated. Many older products used to allow you to select the highest 12-month period over the past 2 to 3 years (prior to incapacity).4. Typically, you may be able to claim an income protection benefit if you are unable to perform the duties required in your ‘own occupation’ i.e. the occupation/role in which you are employed. However, the new products typically loosen the definition for any claims that last more than 2 years. In this case, the occupational definition is reduced to ‘any suited occupation’. The insurer will determine what is a suited occupation based on your skills, training, qualifications and experience. Some policies will pay a reduced benefit amount after 2 years if the insurer person is not “seriously disabled”.An additional change expectedAt the moment, many insurance contracts are non-cancellable which means as long as you keep paying the insurance premium, the insurance provider is locked into providing coverage and it cannot alter the terms (depth and quality of coverage).However, we expect that contract terms will be limited to maximum of 5 years only. That means every 5 years the insurers can alter the terms of your insurance cover, which you can either accept or choose to cancel the policy.(A) Implications if you have existing coverIf you have an income protection policy that went into force prior to 1 October 2021, then you should think very carefully before making any changes, such as reducing the benefit amount or cancelling it. That is because you will never be able to obtain a commensurate replacement policy in the future.The reality is that you may be forced to change, eventuallyThe reason that older policies are no longer available is that they are becoming too expensive for the insurers to maintain. It will be very tempting for insurers to continue to increase the premiums for legacy products to encourage more people to move over to the new, more sustainable products. Premiums have already risen significantly over recent years so it’s quite possible that trend will continue.If the cost of your existing policy comes too expensiveWhilst it is true that the new products provide less comprehensive cover, having some cover in place is better than none. Therefore, one way to manage the cost of cover, is to switch to a new product, even though it provides less comprehensive cover. For some people, a hybrid structure might be more appropriate e.g. retain your existing product but reduce the benefit amount so that half of your total cover is under the old comprehensive cover and that other half via a new product.Of course, whether the option to replace your existing cover is available depends on whether you will pass medical (i.e. your medical history) and financial underwriting. It’s important that you obtain financial advice before cancelling any existing cover to ensure you accurately understand all the pros and cons.A recent analysis for a client highlighted that the cost of the new product was approximately 21% cheaper than the existing older products. It is important to note that premium costs can be unpredictable so savings will vary significantly.(B) Considerations if you plan to get cover in the futureIf you do not have a pre-existing income protection insurance policy and need some cover, it is important that you obtain insurance advice from an experienced financial advisor, as product terms and conditions vary significantly.If contractual terms are eventually limited 5 to years, it will be important that your advisor reviews your policy every 5 years to ensure its still appropriate for your circumstances. This has been less critical when contracts were non-cancellable. That is, it was almost forgivable to ‘set and forget’ your insurances. However, in this new product environment, you (your advisor) must be more proactive.Finally, one way to mitigate some of the risk of new products being less comprehensive is to obtain trauma cover. Trauma cover provides a lump sum benefit on diagnoses of a ‘specified condition’. Typically, trauma policies list 30-35 specified conditions. Statistically, for females it is more likely to be a cancer event and for males a cancer or cardiovascular event. Trauma insurance can be used to fund out-of-pocket medical expenses and voluntary time off work, which may be more common given new income protection policy definitions convert to ‘any suitable occupation’ definition after 2 years.Your ability to earn an income is your most valuable assetFor many people, particularly in their 30’s and 40’s, income protection is the most critical insurance product because:1. Often their financial plans are entirely dependent on their ability to earn an income over the next 10 to 20 years. If they were not able to do that, their financial plan would fail; and2. Their ability to earn an income over the next 20 to 30 years is an incredibility valuable asset (i.e. annual income multiplied by 30). In fact, it is likely to be their most valuable asset. Valuable assets should be insured. You insure your car, and that’s only worth a fraction of what your income is worth. When you compare the cost (premium) to the asset value, it highlights how cost-effective income protection insurance can be.It is even more important if you are the sole or main income earner for your family. Therefore, it makes sense to ensure that you have good value-for-money insurances in place to protect you, your family and your financial plan.

Investopoly

How do the big changes to income protection insurances affect you?

I have noticed that more people are attracted to seeking out work that they have a personal connection with, particularly since the beginning of Covid. That is, for a growing number of people, the emotional rewards (satisfaction) that their work offers is becoming more important than the financial rewards. This might include working in the not-for-profit sector, working for a socially conscious organisation or starting their own business.Of course, not everyone has the flexibility to immediately resign from a high paying job. But of course, you can put a plan in place that allows you more freedom and flexibility in the future. I wanted to discuss the common considerations we tackle when working with clients in this regard.Three phases of wealth accumulationIt is important to recognise that there are typically three phases associated with becoming financially free as illustrated below.ChartPhase one: Accumulation – this phase involves accumulating the required quantum of assets needed to fund retirement. That could include acquiring investment property(s), making additional contributions into super, investing surplus cash flow into shares and so on. This phase typically requires you to contribute as much cash flow as possible i.e. to maximise your earnings and minimise your expenses.Phase two: Income flexibility – the main aim of this phase is to give your investment assets enough time to benefit from the power of compounding capital growth. This phase requires you to earn enough income to pay for living expenses and maintain your investment portfolio. That is, you may have flexibility to earn less during this phase either through changing roles or not working full-time.Phase three: Retirement – it probably goes without saying that this phase doesn’t require you to generate any personal exertion income. All living expenses are funded from your investment/asset pool.Therefore, if you would like to get yourself into a position where you have more choices regarding the type of work you do (i.e. less pressure to maximise your income), what you must do is focus on accelerating phase one.This is a less aggressive version of FIREFIRE is an acronym that stands for a movement called Financial Independence, Retire Early. The idea behind FIRE is that you must minimise your expenses as much as possible to allow you to save and invest more, so that you can retire a lot earlier than a traditional approach allows.The approach I have discussed above can probably be best described as a less aggressive version of FIRE. That is, my approach requires you to maximise your income and minimise expenses for a finite period (could be anywhere from 5 to 15 years). This allows you to reduce your personal exertion income for the next period (could be another 5 to 15 years) as long as it’s enough to cover your living expenses. By doing so, you delay the need to ‘eat into’, your financial resources. It allows your investments to benefit from compounding growth until you can start to draw on your superannuation (from age 60).Maybe you don’t need to earn as much as you thinkOne of the advantages of formulating a plan is that it quantifies what income you need to generate and for how long in order to reach your goals. If you already have a reasonable asset base, it is possible that you may already have the flexibility to reduce your personal exertion income.Specific financial planning considerationsI have listed below some common considerations we encounter when we formulate a financial plan for a client that wants to have more income flexibility in the future. Of course, every clients’ situation and goals are unique, so the matters below are generalisations.You must begin as soon as possibleIt is important to begin your investment journey as soon as possible because a key ingredient for building wealth is time. There are no shortcuts to substitute for the financial impact that compounding returns produce – it just takes time. Warren Buffet put it succinctly when he said “No matter how great the talent or efforts, some things just take time. You can't produce a baby in one month by getting nine women pregnant.”.Consider being more aggressive e.g. maximising surplus and borrowing moreIn phase one you must be as aggressive as possible, but not too aggressive. An aggressive approach to investing can include tactics such as borrowing more money to invest, investing in riskier asset classes (such as emerging markets and private equity/small cap fund, etc.) and so on.If your goal is to accumulate a certain amount of assets as quickly as possible, it is likely you must consider adopting an approach that is more aggressive than what a traditional retirement strategy requires. But that is not to say that you should take unacceptable risk. The risk must be appropriate. You can mitigate risk by doing certain things such as adopting evidence-based approaches, formulating debt exit strategies, not putting all your eggs in one basket and so on.Need to focus on non-super investments (to access prior to age 60)If your goal is to retire before age 60, then you must ensure you have sufficient assets (investments) outside of super to allow this. These assets should either produce a high level of income after all expenses (including interest) or be liquid to allow you to progressively sell down. Residential property, for example, rarely meets with these requirements. However, shares are often the perfect asset class.There’s less room for errorIf you are in your 30’s and are happy to work until at least 60, then you have 30 years to build wealth. Also, since you plan to retire after you can access super, it is likely that super will play a big role in funding your retirement. As such, even if you make a few investment mistakes in your 30’s and 40’s, you probably have enough time to make up for them.However, if you are in your 30’s and would like to have the flexibility to reduce your income (work fewer hours or do different work) by the time you reach late 40’s or early 50’s, then you have less tolerance for mistakes/errors. Therefore, there’s a greater need for you to obtain professional and independent advice to avoid making mistakes.Family home downsizingIf you expect to have substantial equity in your home in the future, then it may be possible to develop a strategy that allows you to have more income flexibility in the future by putting this equity to work.Of course, that will require you to sell the family home and either downsize or relocate i.e. spend less money on a replacement home and invest the difference. Sometimes doing this perfectly aligns with a clients’ lifestyle goals anyway e.g. when they seek a tree or sea change i.e. sell the family home in the city and relocate to the country.Remember, the role of financial planning is to help you achieve your lifestyle goalsA traditional approach to retirement planning included working in your currently role/job until you could access super (age 60). However, the whole point of financial planning is to design a plan that meets your goals, not the other way around. If you no longer enjoy climbing the corporate ladder (or whatever your job entails), it might be time to start planning.

Freedom to choose the work you do for love, not money (how to plan)

Federal Treasurer, Josh Frydenberg has asked the Council of Financial Regulators to investigate the fact that credit growth is materially outpacing growth in household income and to advise on any policy responses.In lay terms, the Treasurer is worried that people are borrowing too much money compared to their incomes and that could be risky for the economy.Increase in home lending is pronouncedIt has been well documented that house prices in Australia have been rising at a fast pace over the past year. But this isn’t unique to Australia. This is also a global phenomenon, as illustrated in Knight Frank’s Global House Price Index report released last week. This report ranks the house price growth in 56 countries and Australia ranks 18th.It is higher loan volumes that have caused higher property prices. The ABS chart below shows that most of the increase in lending has been driven by owner-occupiers (being the dark blue line), not investors.CHART ON WEBSITEThe monthly volume of home loans has been rising significantly since mid-2020. The average volume of lending between December 2020 and August 2021 was $21.7 billion per month. The average for the 10-year period prior to June-2020, was only $11.6 billion per month.Approximately 60% of the increase in lending over the past 9 months has been driven by an increase in the number of borrowers. And 40% has been driven by an increase in the average loan size i.e. people borrowing more. This makes sense as higher income earners have largely been (economically) unaffected by the Covid lockdowns.Level of household debt is a worryThe chart below illustrates how the level of household debt (blue line) has increased over the past three decades. The green line depicts the interest cost of this debt. The interest cost has remained relatively contained for the past decade, thanks to falling interest rates.CHART ON WEBSITEHousehold budgets will clearly be more sensitive to future interest rate increases because they have more debt. This means that any future increases in the RBA Cash Rate will be more effective in containing inflation (by cooling consumer spending). As such, it is entirely possible, even likely that interest rates may never return to pre-GFC levels. That is, it’s possible that interest rates will permanently remain below 6% p.a.The upshot of this is the government is rightly concerned about households’ higher indebtedness. This may be acceptable whilst interest rates are unusually low, but it could cause problems for some borrowers when interest rates inevitably rise.Likely intervention: income to debt capThe banking regulator considers a high debt-to-income ratio as anything above 6 i.e. borrowings greater than 6 times your family’s gross annual income. Therefore, if your family’s income is $200k p.a. and you have borrowings more than $1.2 million, the regulator considers you to be a riskier borrower.The chart below (froman APRA report) highlights that high debt-to-income lending (dark blue) has increased since last year. In fact, it grew by 2.8% in the June 2021 quarter which is the highest increase on record.CHART ON WEBSITEIt is this cohort of borrowers that I expect the regulator to target. It can do so by instructing the banks to reduce lending to borrowers that have high debt-to-income ratios i.e. greater than 6 times, which I think is prudent.Asset-rich, income poor are locked out of the borrowing marketAsset-rich, income-poor borrowers will further be disadvantaged. As I wrote several months ago, banks only lend against income, not assets. That means if you have $20 million of cash in the bank and no job, most mainstream banks will not lend you a cent! Inflexible lending rules do not allow a bank to consider your asset base as a source to fund loan repayments (only income). Of course, this is nonsensical.Consider an example where a borrower owns their home worth $1 million, an investment property worth $1.2 million, a share portfolio worth over $2 million, $500k in cash savings and has zero debt. For lifestyle reasons, the borrower only works casually and earns $20k p.a., but has the capacity to work full-time, if required. In this situation, this borrower has almost no borrowing capacity. Practically, this investor could borrow safely.The point I’m attempting to make is that implementing restrictions such as a debt-to-income caps is often necessary and prudent. However, lenders must have the flexibility to work outside of these parameters where appropriate. Unfortunately, they almost never have this flexibility or are unwilling to exercise it.High income borrowers are in the box seatMost people with a family income of $1 million, for example, probably wouldn’t want or need to borrow materially more than $6 million, so the implementation of a debt-to-income cap will not have any impact on their plans.However, borrowing capacities for lower income earners will be adversely impacted. A restriction on borrowing capacity will retard their ability to afford a house in their desired location and/or their ability to invest in property.Whilst this isn’t an unacceptable outcome in isolation (as borrowing say 10 times income, for example is rarely a good idea), it will unfortunately exacerbate wealth inequality.What does this mean for the property market?It is my view that any change to debt-to-income ratios will probably not have any measurable impact on blue-chip, investment-grade locations. There are enough borrowers with strong financial positions to underpin demand for investment-grade property.However, expected tightening in lending rules will likely impact locations that are populated with a higher proportion of lower income earners.

Likely tightening in lending rules is unlikely to impact investment-grade property

Personal insurance is becoming more difficult to obtain and increasingly costly to maintain. This blog outlines the approach we take when formulating how much insurance our clients need and strategies to manage its cost.What is personal insurance?This blog refers to personal insurance only. That typically includes up to four products:§ Income protection insurance – which pays a monthly benefit if you are unable to work due to illness or injury;§ Life – pays a lump sum benefit if you die;§ TPD – stands for Total and Permanent Disability which pays a lump sum benefit if you are unable to ever return to work in the future, due to illness or injury; and§ Trauma – pays a lump sum benefit if you are diagnosed with a ‘specified condition’ which, statistically, includes cancer and cardiovascular events. Even if your ability to be able to work is not impaired, you can still claim a benefit. Benefits are paid according to diagnoses, not symptoms.Other common insurance products such as health, house and contents and car insurances are defined as ‘general insurance’ products. These are the domain of general insurance brokers, not financial advisors.What determines how much insurance you need?In most situations, the two key factors which dictate how much insurance you need are:1. Financial commitments and obligations including mortgages, living expenses, children’s education, dependents and so on. The higher the levels of commitments, the more insurance cover you need. I view the cost of insurance as a necessary consequence of borrowing money. That is, if you aren’t prepared to obtain insurance to reduce your risk, then perhaps you should reconsider borrowing.2. Your financial strength or net worth. The stronger your asset base is, the less insurance you need, as you have sufficient financial resources to maintain living expenses and meet goals for the rest of your life in the event you cannot work. Of course, if you do not have sufficient assets, you need some level of insurance cover.Your requirements often depend on your stage of lifeIn the below video I walk you through the four common life cycle phases and how they relate to your insurance requirements.[Embed video https://vimeo.com/615661071]SingleWhilst young adults typically have very small asset bases, they also tend to have very few (or no) financial commitments or dependants. As such, they tend to need very small levels of insurance cover, or possibly none.Young familyWhen you buy a home and start a family, your insurance requirements are probably at their lifetime peak. That’s because your financial obligations tend to be most significant (e.g. large mortgage, cost of raising children for the next 18+ years, etc.) at the same time as your asset base being relatively low. It is convenient that insurance is relatively cost-effective in your 30’s, so having an adequate level protection is often affordable.As your kids get older and your asset base grows, arguably you can begin to reduce your level of cover, particularly as it becomes more costly.Empty nestersAs your children approach financial independence and you have concentrated on repaying your home loan, it may be appropriate to begin reducing your insurance cover, particularly as it becomes a lot more costly in your 50’s.Income protection becomes less valuable the older you are because it usually only pays a benefit until you are age 65. If you are 30 years of age, you are essentially insuring the next 35 years’ worth of income, which is a very valuable asset. However, if you are 58, you are only insuring 7 years of income, which is far less valuable, especially since it is so costly in your late 50’s.RetirementAssuming you have sufficient assets, it is safe and appropriate to cancel all insurance cover when you are 2-3 years away from retirement.How much do you need?You need sufficient cover so that you will still be able to achieve your goals even if you are unable to work. That can include covering things such as:§ Replacement of living expenses. If a surviving spouse will continue to earn an income, you may only need to replace a portion of living expenses;§ Repayment of debt. This would typically include the full repayment of any home loan and partial or full repayment of investment debt (at least to the extent that investments become neutrally geared);§ Compensate for investment asset deficiency i.e. if the client is not expected to have sufficient assets by retirement age; and/or§ Funding of specific goals such as children’s education.The tension between insurance premiums and building wealthReducing the cost of insurance frees up more cash flow to invest. The more you invest, the more wealth you will accumulate, and the less insurance you need. It is a “chicken or the egg” type situation.It is my view that you must find an acceptable balance by being willing to accept some risk, but not an unacceptable amount of risk. Optimising your insurance cover involves obtaining the appropriate levels of cover, with the highest quality policies (i.e. terms of cover) at the lowest cost. To use a common vernacular, you must get the best bang for your buck.But if I can’t work, I can sell investmentsSometimes people think selling assets is an adequate response if they are unable to work. This may help you repay/reduce debt, but it creates another problem. That’s because the role of investments was to help you fund retirement. Therefore, selling assets tends to be a short-term solution that creates a long-term problem.Important warning about new income protection insurance productsIf you have an existing income protection insurance policy with a retail insurer, you should think carefully about cancelling or reducing your cover. That’s because new insurance products provide substantially less cover, particularly if you are incapacitated for the long term.Insurance providers have not yet released all information and pricing, but we are aware of some big changes including reducing the contract term to 5 years (used to be non-cancellable), reducing benefits for claims that last longer than 2 years, relaxed disability definitions (i.e. less comprehensive cover) and so on. I’ll write a detailed blog about this when all details become available.Your investment strategy must inform your insurance needsConstructing a well-thought-out long-term financial plan makes it a lot easier to develop an insurance strategy because these two matters are closely interrelated. If you have a low asset base, then it’s likely you need more insurance. At the same time, you need to develop a plan to help you improve your financial position, which will eventually allow you to reduce your insurance cover. A holistic approach to insurance advice yields the best outcomes.

How much insurance is do you need? And how do you minimise its cost?

How to value stocks – an introduction to valuation conceptsTwo years ago I wrote a popular blog that explained some simple share market concepts and jargon (see here). Building on this introductory information, I thought it was timely to discuss basic share market valuation principles to help investors assess whether a stock is over or under valued.To be clear, I’m not advocating investing in direct stocks. In fact, there is an overwhelming amount of evidence that demonstrates direct share investing (i.e. picking stocks) fails to produce above market returns over the long run. However, it is still useful to understand basic share market valuation principles.The ‘Efficient-Market Hypothesis’The Efficient-Market Hypothesis (EMH) was popularised by Nobel laureate, Professor Eugene Fama. The hypothesis suggests that share prices always accurately reflect all available information. The idea is that the market is made up of thousands (and in some cases, perhaps millions of people) that analyse all available information in relation to a particular company. Many of them are professional investment managers with a lot of education and experience working 40-80 hours per week. This information informs their trades i.e. at what price they are happy to buy and sell. And it is this process of “price discovery” that determines the value of a stock.My personal view is that the EMH might be true over long periods of time. However, in the short run, it is possible (in fact, likely) that markets can be inefficient. Behavioural economics explains that sometimes investors can act irrationally, driven by overconfidence, overreaction, overexuberance, greed, fear and so on. The “meme stock” behaviour earlier this year is a perfect example of how markets can be inefficient and stock prices can be wrong.This is why it’s useful to understand basic valuation principals.The value of a business is equal to the present value of its future cash flowsThe value of any business is equal to the present value of its future cash flows. To calculate that, you need to forecast the business’ free cash flows and then apply a discount rate to express the value in today’s dollars. The discount rate must reflect the risk associated with the cash flows e.g. the higher the risk, the higher the discount rate. This is called Discounted Cash Flows analysis.The table below provides a simple example. This business has a 5-year government contract and is expected to generate $100 per year of free cash flow (i.e. income less all expenses including taxation). After 5 years, the business is not expected to continue. Because the business’ revenue is contractually guaranteed and therefore low risk, a lower discount rate of 8% has been used. The discount rate reflects the return an investor would require to be compensated for the risk. Each year is discounted in today’s dollars using the discount rate. For example, refer to year three. The present value of $100 is $79.38. That means if I have $79.38 today and earn 8% p.a., I’ll have $100 in 3 years from now.The aggregate value of the present value of future free cash flows is the business’ value, which is $399.See hereShortcut method: valuation multiplesCompleting a DCF analysis is time consuming and there’s probably not enough publicly available information. A shortcut valuation method is to use a valuation multiple. I have listed the common valuation multiples below.§ Price/Earnings – the PE ratio is probably the most common valuation ratio. It measures the value of a company compared to its earnings per share (EPS). The higher the PE, the higher the valuation and the riskier it is. The average PE ratio over the past 20 years is circa 26 for the US market (S&P500) and 18 for the Australian market. The US market’s PE is currently trading at around 34 times and the Australian at 29 times, which is probably due to two factors. Firstly, temporarily lower earnings due to Covid. Secondly, elevated valuation multiples.§ Price/Sales – the price/sales multiple is used as a check/secondary measure or for businesses that are not yet profitable (and are expected to benefit from huge scale, such as tech companies, and be profitable in the future). The shortcoming of the price/sales multiple is that it doesn’t consider a company’s profitability which is ultimately a very important factor.§ Price/Book Value – the price/book ratio compares the value of a company to its net asset value on its balance sheet. Price/book multiples typically range between 1 and 3 times. This valuation metric is less meaningful in some industries, particularly ones that have valuable intangible assets, as these are rarely included on balance sheets.Two factors that impact valuation multiplesGenerally, there are two factors that will influence valuation multiples:§ Risk – how likely is it that the business will deliver its expected results? Does it have a well-established business? Does it have a strong track record of profitability and paying dividends? Does it have a strong financial position with little debt? These are some examples of things you must consider in order to ascertain a business’s risk. Riskier businesses attract lower multiples/valuations.§ Growth – does the company have profitable growth prospects? All things being equal, higher growth businesses attract higher valuation multiples. By comparison, businesses that are mature and have limited growth prospects attract lower multiples.The relationship between risk and growth are illustrated below.See hereFactors I consider when assessing a stock’s relative valueBelow is a list of factors that I consider when assessing the relative value of a stock.§ PE multiple – relative to its historical levels, peer companies and the market in general.§ Profitability and dividends – I review historic cash flow, revenue, profitability and dividends to consider volatility and growth.§ Financial strength including cash holdings and debt exposure.These three measures usually provide a good, high-level indication of a stocks relative value.Using Woolworths as an exampleLet’s apply these considerations to Woolworths (WOW) as an example:§ Its PE is trading at 32 times which is very high for a relative mature, low growth, low risk business. Its peer company, Coles is trading on a PE of 22.5 and Metcash (which operated IGA supermarkets) on a PE of 16 times.§ Woolworths’ sales, cash flow, earnings and dividends have been quite stable over the past 4 years.§ It has a very strong balance sheet with low and reducing external debt levels.Overall, I assess Woolworths as a low risk, low growth business and would expect a PE ratio of 18-24 times to be fair value. Based on forward earnings, it suggests its shares are probably valued towards high $20’s. Since its currently trading at over $39, it appears to be overvalued in my opinion.Examples of irrationalismApplying this fundamental analysis to some other stocks results in mindboggling outcomes. Here are a few irrational examples from Australia and overseas:§ Accounting software provider Xero is trading on a PE ratio of over 1,000 times!§ REA Group (operates realestate.com.au) is trading on a PE of over 60 times§ Afterpay is valued at $37 billion and lost almost $160 million last year (and has never made a profit).§ Uber is worth over $100 billion and lost over $9 billion last year!§ Tesla is worth over $1 trillion and is trading on a PE of around 400 times.High growth companies can be rewarding to invest in. However, there’s no point in paying too high of a price for the stock, as all you are doing is pre-paying for whatever growthmight occur in the future. And if the growth doesn’t occur, it will be your loss.Clearly some stocks are trading at unsustainable levels and should be avoided.Stock valuations are inherently uncertainStock analysts spend their whole working life analysing companies to identify investment opportunities. But most of them fail to beat the market. A superior share investment strategy is to adopt a rules-based approach, as these tend to offer a lot of diversification and very low fees. You can incorporate factor-based methodologies that allow you to avoid investing in overvalued sectors and companies.

How to value stocks - an introduction to valuation concepts

Over the past 20 years, the US share market has risen 5-fold, the Australian share market 5.4-fold and Australian property 4.2-fold. That means if you invested half a million dollars 20 years ago, in either shares or property, it should be worth between $2 and $2.5 million today. You’d have even more money if you added some gearing.This observation raises an interesting question. That is, why aren’t more people independently wealthy? I suspect the answer lies in their actions, or more correctly their inaction.We make emotional decisions not logical onesIt is a widely accepted fact that we make decisions based on our emotions (how we feel) and then rationalise these decisions with logic. Often, we do this unconsciously.We’d like to believe that we are logical and rational animals. But the truth is that we are not. Our decisions, particularly about money, are shaped by our beliefs, upbringing, our peer group, past experiences and culture. We tell ourselves stories about money. And then we use confirmation bias to validate those stories.Self-awareness and reflection are probably the greatest gifts as they help you recognise how you think, so you can stop allowing emotions influence your financial decisions.Building wealth requires a logical, pragmatic and rational approach. Emotions are not only unhelpful but can be dangerous.Common fear # 1: Paying attention will be painfulSometimes it feels easier to stick our head in the sand and ignore a (potential) problem. For example, most people know that it’s not financially prudent to spend all income on lifestyle expenses. They probably realise that they should be investing/saving some of their income. But to do that, they will have to admit to themselves (and maybe others) that they have been doing the wrong thing in the past. It feels less painful to ignore the issue and “get to it one day”.The problem with ignoring financial misbehaviours is that they magically don’t disappear. They compound. Just like good financial decisions compound, so do bad ones. The longer you ignore it, the worse the consequences will be. And those consequences will be forced upon you at some point in life. For example, you will have to stop working at some point in your life and it’s that point that you will rely on your savings/investments or lack thereof.Often, people in this situation will not do anything until the perceived pain (consequences) from not changing becomes greater than the pain of changing. This often occurs when they are 5-10 years from retirement. They start to think that they’d better start investing before it becomes too late.The solution is to educate yourself about the cost of procrastination. Spending all your income for a couple of years is not a big deal. But doing it for 20-30 years may cost you dearly.Common fear # 2: Investing is too risky. I could lose my moneyWe work hard to accumulate savings. We make sacrifices. And having savings in the bank helps us feel financially secure. Of course, we don’t want to lose that money.When you invest, you do so with the intention of generating future returns. Of course, investment returns are not certain. Investment returns can vary from initial expectations. This is called investment risk - i.e. the risk that you don’t achieve your targeted investment returns.This perceived risk can paralyse some investors into doing nothing.The reality is that risk is black or white. In fact, it is very easy to increase or decrease investment risk within a portfolio through asset allocation. Therefore, the consideration should be how much risk can you tolerate?Most importantly, I think the best way to reduce risk is by adopting evidence-based strategies. That is, employ rules-based approaches that are supported by an overwhelming amount of empirical evidence that demonstrate they work.Common fear # 3: If I try, I may failNo one likes to feel foolish (although, maybe Carlton supporters are the only exception to this rule). Sometimes it feels less risky to not try something and let failure or success remain uncertain. This fear is like # 2, but its less about losing capital and more about successfully achieving goals. Or maybe it’s more about ego?My response to this fear is to highlight that doing nothing is perhaps the riskiest thing of all. It is highly likely that you will fail to achieve your goals if you do not invest.Of course, it is risky to invest if you don’t know what you are doing. But if that’s the case, ask for help. Leveraging the knowledge and experience of people that have achieved what you are looking to achieve gives you the highest probability of being successful. In this situation, it’s a who question, not a what question (which is discussed here).Common Fear # 4: People like me never get aheadAs I mentioned at the start of this blog, often our thoughts about money are shaped by our childhood, experiences and the people we spend time with. People tell us stories about money and these stories echo in our own mind. These can give rise to limiting beliefs.You must first acknowledge these limiting beliefs exists to be able to break this cycle. The above article recommends you identify, reframe and move forward.Common fear # 5: Life’s too shortNo one knows how long we have left on the planet. So, we should always make the most of today. For some people, this extends to how they manage money i.e. spend for today and save nothing for tomorrow.Building wealth is a journey, often a long one. So, we must enjoy the journey in case we aren’t lucky enough to live a long and healthy life. In practical terms, this means spending some money today whilst at the same time, saving (investing) some for the future. Investing doesn’t necessarily require you to curtail all enjoyable activities. In fact, the sooner you begin the investment journey, the fewer compromises you will have to make (my recent blog is evidence of that).Combatting these fears?You can’t address something if you don’t know it exists. Therefore, the first step is to consciously reflect on your decision making and the stories you tell yourself about money. Once you do that, you may become more open to considering evidence that refutes some of your beliefs. The good thing about investing is that it is rooted in simple logic and math, unlike emotions, so it’s easy to verify.Of course, engaging an independent financial advisor allows you to outsource decision making to someone that not only has substantially more experience than you, but also has no emotional baggage about your money.

Mastering a successful mindset... 5 fears about money

Borrowing to invest in property is a popular and highly effective wealth accumulation strategy if it’s implemented correctly. However, loan structuring can often be an afterthought. The reality is that loan structuring and maximising your borrowing capacity is almost just as important as buying the right property. This blog sets out how to structure your loans to build a property portfolio.A step-by-step exampleThe video below takes you through an example of how to structure your loans.See video here. Step one: access equity (deposit loan)You will need to pay a deposit (usually 10%) when you purchase a property. Therefore, you need to arrange access to these borrowed funds. Even if you have access to cash savings, I still recommend that you establish a new loan. This blog explains why this is important.I recommend arranging a loan sufficient to fund 20% of the property’s value plus all costs in addition to a buffer. This loan will be secured by an existing property e.g. your home.Step two: arrange an 80% loanYou will be able to fund 20% plus all costs from the deposit loan. Therefore, you need to arrange a second investment loan to fund the remaining 80%. This loan will be secured by the investment property only. This loan should be pre-approved before you purchase.Step three: consolidate loansWhen your investment property’s value has risen by 35% to 40% above the purchase price, which could take 5 to 7 years, you should be able to consolidate the deposit loan with the 80% loan so that all the debt is in one loan solely secured by the investment property. In this case, your home is no longer required as security.This structure avoids cross-securitisation which is important as explained in this blog.Additional investment propertiesIf you plan to invest in multiple properties, you can repeat the steps above. For simplicity, it is acceptable to maintain one deposit loan to fund deposits for multiple properties. If you do so, you must maintain good record keeping. Personally, I maintain a spreadsheet that includes a list of all purchasing costs, as that helps me verify loan amounts and calculates the investment property’s cost base for CGT purposes.Current considerationsThe table below sets out how we generally structure interest rates and repayments in the current environment. Of course, if you are reading this blog after 2021, these recommendations may no longer be appropriate.See table here. Successful investors don’t care about interest ratesBorrowing costs (interest rates and fees) are important, of course. However, maximising your borrowing capacity in a safe and prudent manner is far more important… about 8.5 times more important to be specific!There are two important benefits resulting from having a higher borrowing capacity. Firstly, you will be able to afford to invest in a higher-quality asset. Higher quality assets generally exhibit higher long-term capital growth rates and lower investment risks. Secondly, it may help you invest in more assets i.e. buy another investment property.I would rather pay a higher interest rate if it allowed me to invest in a better-quality asset. For example, paying 0.50% p.a. in additional interest on $1 million loan will cost you less than $53,000 after tax over the next 20 years in today’s dollars. But a 1% higher capital growth rate will make your approximately $450,000 more in equity after tax (CGT). That equates to an 8.5 times return on your investment! That is why maximining your borrowing capacity is far more important than minimising your interest rate. Of course, it is a great outcome if you can optimise both, but never, ever compromise on borrowing capacity.You should expect to refinance every 2 to 5 yearsRefinancing loans is an administrative pain. Anyone that has set up a new loan over the past few years can attest to that. The amount of information you need to provide to the banks (often multiple times) and the number of forms that need to be completed is staggering. But the reality is that lenders (banks) change lending appetite and credit policies almost as often as the wind changes. Therefore, whilst your existing lender/s might be suitable for you today, there is no guarantee they will be in 3 years from now, for example. In fact, there’s a good chance they won’t be. Successful investors know that finance is a game and you’ve got to be willing to play that game. That includes switching to a new lender when necessary. Avoiding a refinance is easier. But sometimes the easiest path is not the most effective.An experienced mortgage broker is vitalAn experience mortgage broker will be able to help you structure your loans to ensure you maximise any tax benefits as well as your borrowing capacity. The benefits that an experienced mortgage broker can/should provide you, in addition to loan structuring, include:§ Knowledge and experience. The lending industry is a very dynamic marketplace. Things are changing all the time; credit policy, interest rates, laws, regulations, credit appetite and the list goes on. You need an experienced broker to help you navigate these risks and opportunities. Someone that goes into bat for you. That represents your best interest.§ Whilst loan applications are neither enjoyable or instantaneous, a professional mortgage broker will save you a lot of time through completing forms, answering inevitable (and often banal) questions from the lender, following up matters to avoid delays, liaising with other providers such as your accountant and lawyers and so on.§ Proactively re-pricing loans. This chart from the RBA clearly shows that existing borrowers are paying higher interest rates than new borrowers. That’s because higher discounts are typically offered by the banks to attract new business. Therefore, it is important to periodically re-price loans to ensure you are receiving the highest interest rate discount possible. My firm is currently implementing a technology tool that uses an algorithm to trawl over our client’s loans and automatically apply for higher discounts when they become available. It automates the whole process, so our clients don’t need to do anything.Building wealth is a game of finance, not propertyInvestor and educator, Michael Yardney says “property investment is a game of finance with some houses thrown in the middle”, and I couldn’t agree more. To master any game, you must learn the rules. And if you would like to do that, I suggest you grab a copy of my book, Rules of the Lending Game. For a limited time, you can buy a copy of this book for only $20 (free postage) if you use the code BLOG. Books are mailed by Australia Post so please allow 1 – 2 weeks for delivery.

Loan structuring 101: How to finance a property portfolio

Investing in the share market is a relatively easy, simple and a low-cost investment strategy to implement, if you know the right way to do it, of course. However, if you don’t know what you’re doing, it’s easy to mess it up. In this blog, I set out how to implement a highly successful (over the long run) share market investment strategy using a low-cost, evidence-based approach.Of course, the information in this blog (and in fact, in all my blogs) is general in nature. It’s not written or tailored for you, as I do not know your personal circumstances, goals, risk appetite and so on. Therefore, be careful. If you have any doubt, always seek independent financial advice.There are three steps to implementing a share market investment strategy.Step one: chose your investment methodologyWhen investing in the share market, you have three broad options:1. Invest in direct shares i.e. pick the stocks that you would like to buy;2. Employ the services of professionals to pick the stocks on your behalf e.g. use a stockbroker or actively managed fund; and/or3. Invest in low-cost index funds (this could be described as a rules-based approach to picking which stocks to invest in).Regular readers of this blog will know that I strongly believe in only employing evidence-based investment approaches. And there’s an overwhelming amount of evidence that demonstrates that index investing has the greatest probability of generating the highest returns over the long run. If you’d like to learn more, I present this evidence in this blog and also in my book, Investopoly.Some people are attracted to investing in shares for fun (i.e. a bit of excitement). A perfect example of this is what happened to US stock, GameStop and other meme stocks. The core purpose of investing is to build wealth, not to have fun! In fact, if done correctly investing should be boring. Although the process might be boring, the outcome is exciting!Step two: pick the productNow that you have decided to adopt an indexing methodology (if not, return to step # 1!), it is time to pick the product you will use.I strongly recommend you use a diversified product. A diversified product invests in a variety of sub-asset classes such as Australian shares, international shares, emerging markets, bonds and smaller companies. The asset allocation is professionally managed which means there’s less room for error. Currently, two Australian ETF providers offer these products:§ Vanguard – VDGR has a very broad asset allocation with 70% invested in shares and 30% in bonds. VDHG has a more aggressive asset allocation with 90% invested in shares.§ BetaShares – DHHF is 100% invested in shares i.e. no bonds.§ Ethical investments – BetaShares also has some ethical options including DGGF (70% in shares) and DZZF (90% in shares). These funds screen out companies that are large carbon dioxide emitters i.e. fossil fuels.Whilst bond returns are currently low, bonds still play a very important role in a portfolio because they have a negative correlation with shares. How important this is to you depends on your situation and risk profile.BetaShares products are relatively new (established in Dec 2020). However, the Vanguard funds have a much longer track record (established in 2002), albeit in managed fund form (and only recently offered in an ETF form). You can view long term returns here and here. Both have returned over 10% p.a. over the past 10 years.In terms of how to invest in these ETFs, you can do that using an online share trading account. If you invest in Vanguard’s ETFs, you can use its new Personal Investor service which allows you to buy one of its listed ETFs for only $9 per trade. If you want to invest in a BetaShares ETF, you need a retail share trading account such as CommSec.Step three: implementationBecause the share market can be highly volatile, the best way to invest is incrementally in small tranches over a long period of time e.g. monthly or quarterly. This helps spread your timing risk. Timing risk is the risk that you lose money because you picked the wrong time to invest a lot of money in the share market i.e. just prior to a crash. This chart is a good reminder of how volatile the share market can be. Therefore, you need to decide how much you are comfortable investing each month or quarter. One of the advantages of a share strategy is that you can increase or decrease this amount if your circumstances change. It is very flexible.Some additional considerations include:OwnershipYou will need to think how to own these investments. Typically, your options include sole name (you or your spouse, if you have one), joint names (if you have a spouse) or a family trust (click here for a presentation about family trusts). It may be worth speaking to your holistic accountant about this.GearingDepending on your goals, circumstances and risk profile, you may consider boosting your regular investment amount with some borrowings. For example, if you had $3,000 per month of surplus cash flow, you could set up an investment loan (mortgage) secured by your home and draw $3,000 per month from that loan. This would allow you to invest $6,000 per month funded 50% from cash and 50% from borrowings.What results can you expect?The chart below sets out the results an investor could have achieved if they started investing $3,000 per month 20 years ago. The investor’s investment portfolio would be worth $1,828,000 today consisting of $720,000 of capital contributions plus $1.1 million of growth. And if they continue investing, the investor’s portfolio could be worth $4.6 million by 2031 i.e. in 10 years from now (consisting of $780,000 of capital plus $3.8m of growth). Pretty extraordinary, right?See chart here. The thing I like the most about this chart is that is demonstrates that sometimes you can do everything right for many years but not enjoy any results. For example, if you started investing in 2001, by 2008 you would have earned zero return (thanks to the GFC). This can happen despite employing a sound, evidence-based approach. But investor’s that have the discipline and fortitude to stick with it, play the long game, have faith in evidence-based strategies, are always well-rewarded in the long run.Financially model your own scenarioClick here to download my regular share investing financial model (Excel spreadsheet). It allows you to alter the monthly investment amount to model various scenarios.When do you need independent financial advice?As described above, this is a simple strategy to implement. However, the more you invest, the greater the scope there is for a financial advisor to add value. They might be able to deliver value in several ways:1. The diversified options mentioned above tend to distribute too much income. For example, the Vanguard Growth fund generated a return of 9.30% in the 5 years ended July 2021. This consisted of 7.07% p.a. of income plus 2.22% of growth (the High Growth fund generated 7.63% income plus 3.48% growth). Obviously, income is taxed each year. But growth isn’t taxed until you sell the investment. For many investors, it’s more tax effective to have more growth and less income. The tax implications become more material with the more money you have invested. Also, there may be other ways to structure a portfolio to minimise tax.2. All diversified investments use traditional market cap indexing only. I have written about the limitations with this methodology in the past – click here. The more money you have invested, the more important it becomes to use a variety of rules-based indexing methodologies, particularly in this market. By way of an update, last financial year (2020/21), fundamental indexing outperformed by 4.5% and Dimensional by 4%. Of course, longer-term returns mentioned in this blog are more reliable.3. An advisor can construct an investment portfolio that is tailored to your specific needs and risk profile. For some investors, capital preservation is more important than investment returns, so investing in safer assets other than bonds becomes important. Other investors are willing to take higher risk and skew their portfolio towards the sub-asset classes and geographical markets that are positioned to provide the best returns over the medium to long term.Whilst it is difficult to formulate a perfect rule of thumb, my view is that if you are investing more than say $3,000 to $5,000 per month, and/or your existing portfolio exceeds circa $400,000 in value, then it is likely that you would benefit from engaging an independent financial advisor to manage your portfolio on an ongoing basis. Notwithstanding that, there might be other things they can help you with.Keep it simple and do it regularlyAs the chart above demonstrates, monthly investing over long periods of time generates substantial wealth. The strategy is flexible and lower risk than borrowing to invest. And there has never been a time when this strategy has been easier and more cost-effective to implement. It is certainly worthy of consideration.

A powerful share market investment strategy you can implement yourself

Approximately half of Australia’s population is currently in a lockdown, and this may continue for another few months until vaccine target levels are reached. I wanted to discuss what impact this may have on the property market and the broader economy.Of course, there are wide ranging impactsThe impact of Covid lockdowns can be wide-ranging. Dealing with the challenges of home schooling, not seeing family, not enjoying your normal pastimes, business failures, job losses, mental health challenges and so on. Of course, we all have a tremendous amount of empathy for the various ways that lockdowns are negatively impacting people’s lives. That said, the aim of this blog is to focus purely on economic impacts only.What we learnt from previous lockdownsThe lockdowns in Australia during 2020 and around the world taught us some valuable lessons, as there were some common themes, namely:§ Low-income earners tend to be impacted to a much greater extent. In fact, it is not uncommon for higher income earners to avoid any negative financial impacts from being in lockdown, because as they can work from home, they retain their employment and income.§ Because people cannot undertake their normal (non-lockdown) activities, we observe two economic trends. Firstly, people save more money (i.e. the savings rate spikes), which improves their financial position. Secondly, people tend to spend more on durable goods – although this trend will probably diminish at some point – how many new appliances do we really need!§ Whilst an increase in business failures hasn’t yet been reflected in insolvency statistics, it stands to reason that each successive lockdown (Melbourne’s onto its 6th) puts an increasing amount of pressure on some businesses, as their financial resources deplete. Anecdotally, unfortunately I have observed a greater number of business closures in the Melbourne CBD over the past couple of months.§ Overall economic demand does tend to bounce back strongly and quickly. At a macro level, demand for spending by higher income earners tends to more than compensate for lower levels of demand by income earners.But we don’t have JobKeeper anymore?The federal government’s Covid-19 Disaster Payment provides an income of $750 per week to those that have lost 20 hours or more of work during a lockdown. The highest JobKeeper payment during 2020 was $1,500 per fortnight, so this is on par.However, according to Deloitte Access Economics, only about 2 million Australian’s were accessing this Disaster Payment in August 2021, compared to 6 million that accessed JobKeeper in March 2020. That means less money from government assistance is being pumped into the Australian economy. That said, the JobKeeper program was widely criticised for its untargeted nature e.g. some large businesses claimed JobKeeper and subsequently declared record profits and dividends (e.g. Harvey Norman). As such, perhaps this Disaster Payment package is more efficient and still just as effective. Regardless, the Australian federal government will rack up more than $1 trillion of debt from supporting the economy through Covid, so it isn’t going to stop now. I expect the federal government will provide more support should it be needed.Apartment rental incomes will be under pressureRenting an apartment tends to be more affordable than renting a house. As such, apartments are tenanted by a higher proportion of lower income earners. Whilst the federal government’s Disaster Payment package will hopefully avoid or minimise financial hardship, it is possible that some residential tenants will seek rent relief (in the form of a waiver of deferral) from landlords.Because Covid has adversely impacted lower income earners to a much greater extent, it is likely that apartment rental income growth will be relatively stagnant over the next one to two years.Vendors are likely to remain cautious about sellingAccording to the REA Group, property listings dropped by over 10% nationally in July, with Melbourne and Sydney experiencing much larger falls. One-on-one property inspections can still be conducted in Sydney, but not in Melbourne. Live auctions have been banned in both cities. As such, almost half of the auctions that were scheduled to occur over the past week in Melbourne were withdrawn.The fact is that vendor confidence is weak. Of course, most people are reluctant to begin a sales campaign in the middle of a lockdown, as sales activities are severly restricted. However, even when we emerge out of these lockdowns, most vendors worry about their sales campaign being interrupted by yet another lockdown.As such, I don’t expect the property market (particularly supply of property listings) to normalise until the risk of lockdowns evaporates, which might not be until next year.Central banks and commodity pricesOne of the challenges with controlling the federal budget deficit will be the impact of the falling price of iron ore. Between the start of December 2020 and mid-May 2021, the price of iron ore rose by 80% from $US125 to $US215 per tonne. This boosted government revenue through mining royalties and company income tax receipts. However, iron ore prices have been falling since the start of August. It is now trading at $US160 per tonne. If this trend persists, it is not good news for the government budget.At the start of this month, the RBA announced that it would reduce its bond buying program from $5 billion per week to $4 billion in September, as it tappers off its quantitative easing (EQ). However, given the huge cost of lockdowns to states and the federal government, most commentators expect it will delay any tapering. Similarly, commentators expect the US Federal Reserve to postpone any planned tapering of its QE program due to rising delta cases in the US. It seems more central bank support might be needed.Interstate migration away from Melbourne and Sydney will almost certainly riseI shared this interstate migration chart a few weeks ago. It is noteworthy that interstate migration has been negative in NSW for quite some time. And Victorian interstate migration is trending downwards to the point that it is now negative (a net loss of 4,900 people in the March 2021 quarter compared to a net gain of 490 people in the March 2020 quarter).I think this trend will continue in that an increasing amount of people will migrate away from Melbourne and Sydney and move to Queensland. Perhaps Melbourne will fare the worst because its lockdowns have been more draconian and therefore likely to have had a more severe social and economic impact.It is important to note that negative interstate migration may reduce demand for property in Melbourne and Sydney at a macro level. However, it is unlikely to have a material impact in investment-grade locations. The reason why is that these locations tend to benefit from multifaceted demand. Therefore, even if one demand factor temporality subsides, it is very likely that overall demand will still exceed supply, thereby resulting in price appreciation.My conclusionI predict that the investment-grade property market will be largely unaffected by the prolonged lockdowns in Melbourne and Sydney. Of course, the practicalities of selling means that transaction numbers will continue to be below trend, whilst restrictions are in place. But once restrictions are lifted and the risk of further lockdowns disappears, I believe demand for property will quickly return to normal. Supply (i.e. properties for sale) is not likely to recover until 2022.However, non-investment-grade locations that are predominantly occupied by lower income earners may not fair as well.Regarding the economic recovery, at a macroeconomic level, I think the economy will bounce back relatively quickly, like it did in 2020. However, unfortunately, some sectors will now take a lot longer to recover (i.e. years, not months) such as hospitality, retail (particularly in the CBD) and tourism.

What impact will the prolonged lockdowns have on the property market and economy?

Land tax is levied on the value of an investor’s landholdings on 31 December each year. It is an insidious tax as any land tax is relatively small when you initially purchase an investment property but typically increases each year. As such, the problem is that it can become quite costly by the time you reach retirement – a time when it’s preferrable to pay less tax, not more.There may be several opportunities to minimise land tax which are discussed in this blog.Land value is a vital attribute of an investment-grade propertyThe value of a property comprises of the value of the underlying land plus the dwelling’s value (i.e. improvements that are permanently located on the land). Typically, land appreciates in value over time whereas buildings depreciate. Therefore, to maximise your property’s rate of capital growth, you must invest in property’s that have a high land value i.e. more than 50% of the property’s value should be in the land.There are a couple of consequences of investing in high land value properties:1. High land value properties tend to produce low rental yields. That’s because renters don’t really care about the value of the underlying land. Renters are more impressed by the size and quality of the accommodation; and2. High land value properties attract higher land tax liabilities.Remember, the power of compounding capital growth more than compensates investors for these disadvantages.In the past, it hasn’t been wise to own property in a company but…One of the major disadvantages of owning investments in a company is that a company is not entitled to the 50% capital gains tax discount.If you realise a capital gain in your personal name of $100, you can discount that gross gain by 50% if you have held the investment for 12 months or longer. As such, the investor will be taxed on a net gain of $50 at their marginal tax rate. If they earn over $180,000 p.a., their rate of tax is 47%, so they will pay $23.50 in tax. In short, the maximum rate of tax in respect of CGT in their personal name is 23.5%.If a company makes a capital gain of $100, it will pay tax on the whole gain as the 50% discount is not available. As the corporate tax rate is 30%, it will pay $30 of tax.In this situation, the investor that uses a company pays a high tax rate by 6.5% (i.e. 28% more in tax). As such, companies used to be an unattractive ownership structure (also because negative gearing losses are trapped).But the company tax rate has reduced in some situationsCompanies that meet the eligibility of ‘base rate entities’ will be taxed at the flat rate of 25% from this financial year onwards. A company is a base rate entity if its turnover is less than $50 million and 80% or less of its income is passive income (which includes rental income).This could create a good opportunity for self-employed taxpayers if they are able to distribute business income into a corporate beneficiary, so that the non-trading investment company meets the ‘base rate entity’ definition. In this case, the rate of CGT would be 25% versus 23.5% in a personal name. This is a far more palatable outcome, especially if a company ownership structure helps reduce land tax liabilities, as discussed below.State based tax regimeLand tax is a state government tax, and each state has different rules. Principal places of residence do not attract land tax. But any properties in addition to your principal place of residence, such as holiday homes and investment properties, typically do attract land tax.Land tax in VictoriaIn Victoria, investors incur a land tax liability if the value of landholdings exceeds $250,000. It has a marginal tax rate system which means the more land you own, the higher rate of tax you pay.It is noteworthy that the land tax free threshold of $250,000 hasn’t change since 2009, despite the median house price almost doubling since then!Joint owners share one land tax free threshold. Therefore, if you own two investment properties, purely from a land tax liability perspective, you are better off for each spouse to own one property each, rather than jointly.Family trusts (click here for the benefit they offer) attract higher rates of land tax, and their land tax free threshold is only $25,000. As such, it if often worthwhile to establish a separate family trust to hold each property, rather than having multiple properties in one trust.Companies are taxed at the same rate as individuals. Therefore, if you are self-employed and can distribute business income into a corporate beneficiary, a company could be a good ownership structure.I have prepared some financial projections which compares various ownership structures depending on whether you own one, two or three investment properties. Click on the image below to view this analysis.https://www.prosolution.com.au/wp-content/uploads/2021/08/Vic-land-tax-charts.pdfLand tax in NSWNSW provides a land tax-free threshold of $755,000. This threshold is increased each year, which is a fairer system than Victoria. The value of land that exceeds the threshold is taxed at a flat rate of 1.6%.The land tax-free threshold is available to individuals, companies and self managed super funds, but not family trusts. That means a property investor that uses a trust to hold property in NSW will always pay $12,080 more in land tax each year, if the value of its land holdings exceeds $755,000 (being 1.6% of $755,000). As such, where possible, it is better to own property in personal name/s or, if you are self-employed, a company (subject to the discussion above).NSW has announced that it will seek to reform property taxes by replacing stamp duty with an annual tax. Whether this will have an impact on land tax is unknown.Queensland land taxQueensland’s land tax regime is like Victoria’s, in that it has a land tax-free threshold (of $600,000) and levies a marginal rate of tax.Trusts, companies and self managed super funds attract a lower tax-free threshold of $350,000 and higher rates of tax. Depending on your situation, it might be wise to spread property ownership across multiple trusts, as discussed above for Victoria. Just like I did for Victoria, I have prepared some financial projections which compares various ownership structures depending on whether you own one, two or three investment properties. Click on the image below to view this analysis.https://www.prosolution.com.au/wp-content/uploads/2021/08/QLD-land-tax-charts.pdfGeographical diversification can help minimise land taxBecause land tax is a state-based tax, it may be possible to benefit from the tax-free threshold in each state. As such, owning three properties in three different states will result in a materially lower annual tax liability than owning three properties in one state.Other factors to considerWhen contemplating investment property ownership options, it is important to recognise that land tax is only one of many considerations. There are many financial and non-financial considerations to weigh up including:§ Capital gain tax and income tax e.g. negative gearing benefits;§ Asset protection;§ Estate planning i.e. transfer of wealth;§ Compliance costs e.g. accounting fees, set-up costs and ASIC fees; and§ Ability to borrow (e.g. maximise borrowing capacity, if applicable).Some of these factors can be just as important, or more important than land tax outcomes.Also, it is very important to acknowledge that tax rules can change at any time. In fact, if you plan to own the property for a few decades, then it is very likely that tax rules will change over this period. That is why it’s important to not be too tax focused. An ownership structure should provide many advantages including the ability to minimise taxes. It’s too late to change nowChanging the ownership of a property that you currently own is often cost-prohibitive as it can give rise to capital gains tax and/or stamp duty liabilities. Therefore, it is important to seek independent financial and taxation advice well in advance of acquiring an investment property to avoid any costly mistakes.As I wrote at the beginning, land tax is insidious – it will sneak up on you. Therefore, you must consider ways to minimise it and you can only do that if you have a well-defined plan.

Land tax minimisation (or elimination) strategies

As a completely independent advisor, I have no vested interest in how my clients invest. Whether they invest in property, shares or any other asset class makes no difference to my life. Of course, I want them to invest in (1) assets that are most appropriate for them and (2) assets that provide the highest returns without taking unacceptably high risk. I know that if I help my clients invest successfully, they will continue to remain clients and therein lies my firm’s success. Often investors contemplate (and compare) investing in either property or shares.The property versus shares debate is meaninglessIt is often debated which asset class is better, property or shares. I view this debate like arguing which golf club is best. Each club has its unique purpose, and the reality is that golfers need many clubs in their bag to play well. Investing is no different. Investing in a mixture of asset classes allows you to balance out the pros and cons of each asset class at a portfolio level. Ignoring any one asset class in totality gives rise to higher investment risk as you are putting too many eggs in one basket.In summary, I think shares and property are equally good asset classes. I believe that most investors should invest in both. I believe that if you employ an evidence-based approach, in the long run, the investment returns produced by property and shares should be materially similar.The big difference is an investors’ appetite for gearingMost people feel more comfortable borrowing to invest in property but less so with shares. There is good reason for that. The chart below is from my book, Investopoly. It sets out the long term returns and corresponding volatility of each asset class.See chart here. The average volatility rate (or standard deviation) for shares is 20.9% and the average long-term return is 11.6% p.a. To put this in non-mathematical terms, two-thirds of the time, you can expect that your annual return from shares to be in the range of -9.3% and 32.5% (being plus or minus one standard deviation from the average). And 95% of the time your return will between -30% and 53% (plus or minus two standard deviations). That is a very wide range, right? And that is why shares are seen as volatile, as return can vary significantly from year to year.However, residential property is a lot less volatile. Two-thirds of the time your return will range between 0% and 20%. And 95% of the time, between -10% and 30%. Whilst this is still a wide range, it’s a lot tighter than shares. That is why people feel more comfortable borrowing to invest in property, because the likelihood of experiencing a loss year (just after you have borrowed to invest) is relatively low (i.e. there were only 6 loss years between 1980 and 2016).How to borrow to invest in sharesI would almost never recommend someone borrow a large lump sum of money and invest it in shares in one tranche, for the reasons described above i.e. volatility. Instead, I would usually recommend investing in a series of regular and relatively small tranches over (hopefully) many years. Doing so helps you spread your market timing risk.This can be a very effective strategy as explained in this video by Vanguard (watch from 1:30min). This example shows that if you invested $500 per month in an Australian index fund beginning in 1990, that by June 2020 your investment would be worth $760,000. This balance comprises of $177,000 of your contributions plus $583,000 of investment earnings. It shows that the strategy of making regular investments over long periods of time (30 years in this case) creates significant value. All you need is the discipline to stick with it and patience.Therefore, I would typically advise an investor wanting to borrow to invest in shares to do so on a regular basis, not in one lump sum.Shares versus property: a practical comparisonI would like to compare two scenarios:1. Establish a loan against the equity in your home and draw $5,500 per month to invest in shares for 15 years i.e. $1 million invested; versus2. Borrowing $1 million today to invest in property.Shares scenarioI have assumed a total investment return of 9.8% p.a., comprising of 3.7% of growth and 6.1% of income (this is based on the past 10 year performance of Vanguard’s growth index fund). Other assumptions include a mortgage interest rate of 6.5% p.a., a marginal tax rate of 39% and that the investor makes a cash contribution into shares equal to the investment property’s holding costs (i.e. the next scenario below).Property scenarioThe investor purchases a house in Brisbane for $940,000 and borrows $1 million to pay for stamp duty and buyers’ agent fees. The property generates an initial rental yield of 3.2% and this rental income increases at a rate of 5% p.a. The assumed long-term capital growth rate is 6.6% p.a. (so that the total return is 9.8% p.a. – same as shares). The interest rate and tax assumptions are identical to the shares scenario.And the winner is…The chart below compares the value of equity for both scenarios. It is obvious that property is the clear winner. That is not because property is “better” per se, but simply because the $1 million of borrowed funds were invested in full from day one (compared to $1 million invested gradually over the first 15 years).See chart here. What is the property capital growth breakeven rate?The mathematical power of gearing can compensate for (or mask) poor investment returns. The property strategy analysed above will be superior as long as the property’s average capital growth rate exceeds 5.85% p.a. This means that it is possible that investing in a property that is sub investment-grade could still work out to be a superior strategy.Of course, I would never endorse investing in a property that is not investment-grade. My point is to not underestimate the power of gearing.The comparison is not fair, but its realisticAs I have stated, the above comparisons have very different gearing levels, so of course the scenario with a higher level of gearing produces superior results. But we must not ignore the fact that gearing increases your investment risks as you have a larger interest rate exposure. That is, you have an obligation to meet a property’s holding costs (from your salary or other resources), whereas the share strategy is self-funding (investment income pays for the interest costs).It is not always appropriate for people to gear to the high level that is necessary to invest in property. This risk factor must be considered.Property can be better, but only because of gearingThe analysis above indicates that gearing into property may allow you to accumulate 25% more equity over 30 years.The property scenario above resulted in an equity value of $2.4 million in today’s dollars ($5.06m in future value) versus $1.8 million for shares (future value of $3.81m). Whilst the differential is material at $600,000 in today’s dollars, considering that the shares strategy is self-funding, I’d argue that both strategies produce relatively good outcomes.It’s probably more of a question of which strategy suits your circumstances and goals best, rather than which is the better asset class.

Property versus shares; a practical comparison

I hosted a seminar in August 2018 where I presented an investment case for (investment-grade) houses in Brisbane in the $800,000 to $1m price range. It was my thesis that they represented excellent value and had a high probability of delivering above-average returns in the medium term. An investment grade house that sold for circa $800,000 in late 2018 would be worth well over $1 million today.Depending on your financial position, existing assets and investment strategy, an investment-grade property in Brisbane might still be an excellent investment. I set out some pros and cons to consider in this blog (in no particular order).Pro: Overseas and interstate migrationThe chart below sets out interstate migration for NSW, Victoria and Queensland. Sydney’s interstate migration has been negative for many years (as a Melbournian, I’ll resist the temptation to disparage Sydney). The clear trend over the past 5 years is that a growing number of people are moving from Victoria and NSW to Queensland. However, historically, almost all interstate migrants move to the Sunshine and Gold Coast, not Brisbane. However, I suspect that Covid might change that trend.See chart here. This next chart sets out net overseas migration since 2004. Overseas migration declined significantly between 2008 and 2015. It was starting to recover but of course Covid has interrupted that. Unlike interstate migration, almost all overseas migrants move to Brisbane.See chart here.Interestingly, New Zealanders tend to represent around half of the total permanent migrants. But fewer New Zealanders have been moving to Queensland in recent (pre-covid) years. The number of New Zealand migrants between 2017 and 2019 ranged between 1,500 and 3,000. By comparison, in 2008 over 16,000 New Zealanders moved to Queensland. A rebound in New Zealand migration could have positive consequences for Brisbane and its property market.I suspect that Covid has highlighted how attractive Australia is as a designation for overseas migrants. And, for some of the reasons highlighted below, Brisbane is well positioned to attract a large share of these immigrants.Pro: Large infrastructure spendingBrisbane is in the midst of a$20 billion infrastructure spend including major projects such as Cross River Rail, Queen’s Wharf Precinct, Showgrounds Masterplan, Brisbane Live entrainment precinct and so on.Last year, the Queensland government completed construction of a second runway at Brisbane airport at a cost of $1.4 billion. It is projected to generate $5 billion of economic benefit over the next 10 years.And of course, Brisbane will host the 2032 Olympic games. KPMG projects that it will deliver $4.6 billion in economic benefits.These infrastructure projects contribute positively to Brisbane’s ability to attract a growing number of overseas and interstate migrants.Con: Smaller city (population)Brisbane’s population is almost half the size of Melbourne and Sydney, which means there are fewer high net worth persons that are willing and able to drive blue-chip property prices higher. As I have written before, property prices will continue to rise in blue-chip locations as long as the demand from a cohort of wealthy individuals outstrips supply. The larger a city’s population is, the more likely that demand will persistently outstrip supply.See table here.Pro: Better affordabilityBuying a family home in a blue-chip suburb (i.e. located 5-12 kms from the city in a good school zone) is still relatively affordable in Brisbane compared to Melbourne and Sydney. A property of this calibre can typically cost in the range of $1 million to $1.5 million. However, in Melbourne and Sydney you need to spend more than double that amount.I think this is a big attraction for overseas migrants, particularly New Zealanders.Con: Job opportunitiesOne of the Brisbane’s downsides is that it doesn’t have a lot of corporate head offices and therefore, attract fewer high-paying executive roles. From a list of 265 notable large Australian business (many of them listed), only 27 of them have head offices in Brisbane (compared to 94 in Sydney and 84 in Melbourne). A city really needs to be large enough to attract a large number of employers that earn substantial salaries.The ‘work from home’ movement might go some way to alleviate this. Depending on the industry and occupational role, it may not be necessary for key employees to live in the same state as the company’s head office.Pro: Lower stamp duty than in VictoriaInvesting in property in Brisbane attracts lower levels of stamp duty than in Victoria. The table below compares the upfront stamp duty cost and ongoing land tax for a property worth $1 million.See table here.It is noteworthy that NSW charges the lowest amount of Stamp duty. However, of course, you are not going to find an investment grade property for $1 million in Sydney, so the comparison is theoretical only. The reality is that purchasing in investment grade property is either Melbourne or Sydney will give rise to a much higher stamp duty bill.Pro: Higher rental yieldInvestment-grade house rental yields in Brisbane range between 2.5% and 3.5%, with the typical yield being close to the midpoint i.e. 3%. This yield is much higher than in Melbourne and Sydney where investment-grade houses are lucky to generate a rental yield of 2%.Based on current fixed interest rates, the annual after-tax holding costs for a $1.5 million property is likely to be less than $10,000.Think long termCurrently you can buy an investment-grade property in Brisbane in a blue-chip suburb such as Toowong, Ashgrove, Paddington for between $1 and $1.5 million. The house will be located on a 400-500 sqm block of land (land value will represent 60-70% of the property’s total value). You will receive a 3% rental yield.I ask myself, what will this property be worth in 20 years? It is certainly not inconceivable that a $1.5m property today will be worth over $4 million in 20 years’ time (which is only a growth rate of 5% p.a.). If so, I have accumulated $2.5m in equity and it won’t have cost me very much money to pay for its holding costs.Conclusion: Could be a good addition to your portfolioFor the reasons discussed above, investing in Brisbane property does have a lot of merit. Of course, whether it suits your circumstances is something I cannot comment on. However, it is important to consider the benefits of geographical diversification. Therefore, if you already have investment exposure to the Melbourne and/or Sydney property markets, then investing in Brisbane could be a good addition to your portfolio.Of course, it is paramount to buy the right property i.e. one that is investment-grade.

Investment case for Brisbane property: Pros and cons

It is not unrealistic to expect your super returns to be over 20% for the financial year ended June 2021. Of course, this is a great outcome in what has been a tumultuous year. However, I would like to highlight some important observations and considerations.And the 2021 winner is…The table below sets out investment returns for the largest 8 industry funds based on a Balanced investment option (data from Lonsec). The table is sorted by 1-year returns, highest to lowest for the financial year ended June 2021. Hostplus achieved the highest return. However, AustralianSuper is the best performing fund over 3, 5, 7 and 10 years as highlighted.See table here.I have selected the relevant pre-mixed investment option that has between 60% and 76% of assets invested in growth assets e.g. shares. This is defined as a Balanced asset allocation. You will note however that some super funds don’t use the Balanced description – some call it Growth or Core and so on. This highlights that it is important to not rely solely on an investment option’s name. Instead it is important to examine the actual asset allocation of the option you are considering.This list of top 10 super funds includes all industry and retail funds (my list above only compared the 8 largest industry funds).Click here to view a similar comparison for a Growth investment option.Often, it’s impossible to understand how your money is investedOf course, it is basic common sense to make sure that you always understand how your money is invested. However, that can be challenging with some industry funds. Most people assume their money is invested in share and bond markets. However, some industry super funds invest a large amount of your balance in “alternative” investments.Alternative investments can include almost any type of investment that cannot be classified as shares, bonds, property or cash. Alternative investments include things such as infrastructure, construction and private credit, hedge funds, private equity, currency, commodities and so on. Industry super funds do not have to disclose any detail regarding these investments. In fact, any information is often value vague so it’s impossible to assess the underlying risk.The chart below (data from Lonsec) highlights that the amount each industry funds allocates to alternative assets. This ranges from 5% (UniSuper) to 33% (Hostplus).See chart here. Risks with alternative assetsThe advantage of listed assets, such as shares, is that price discovery occurs on a daily basis. That is, market participants (investors) often buy and sell stocks. As such, the current price of an investment reflects all publicly available information and the market’s views. It is a very transparent process. This gives investors comfort about what their investments are worth and consequently, how they are performing.However, many alternative assets are not listed assets e.g. shares in an unlisted company (i.e. private equity) or a large infrastructure project. As such industry super funds must periodically engage valuers to revalue these assets.Prior to starting ProSolution, I used to work for a Big 4 accounting firm preparing business valuations. I know all too well that valuations can be highly subjective. The fact is that you never really know what an asset is truly worth until you attempt to sell it. Some commentators have accused industry super funds of using the subjectivity of unlisted asset valuations to their advantage to manipulate investment returns.I note that the government is seeking to improve unlisted asset disclosure requirements but of course the industry funds are opposing the proposed obligations.My other concern with unlisted investments is the lack of transparency and accountability. Investment risk hides in the dark. This is why listed companies have clearly defined reporting obligations – to help investors make informed decisions. However, industry super funds have no such disclosure obligations.Why do super funds invest in unlisted assets?The problem that large super funds face is that they have too much money to invest. For example, in the 2019/20 financial year, AustralianSuper received over $15.5 billion of new money to invest. Super funds therefore must look for alternative investment options.However, this is a super funds problem, not yours. You have substantially less money to invest so it is entirely possible for you to invest it in a ways that is completely transparent and evidence-based.The best industry funds are…Taking into account past investment returns, fee levels and the desire to minimise exposure to alternative assets, it is my view that UniSuper and AustralianSuper are the two most attractive industry super funds.AustralianSuper is Australia’s largest super fund. Its allocation to alternative investments, which consist of only infrastructure and direct property, is not unacceptable at 17.5%. Its investment fee for the Balanced investment option is 0.63% and it’s the best-performing fund over long period of time.UniSuper was only available to people employed by Australian universities. However, from 1 July, it is now open to the public. It only invests 5% in alternative assets which consists of infrastructure and private equity. Its investment fee for the Balanced investment option is very low at 0.46% and its long-term investment performance has been excellent.Of course, this information is general in nature, and you must not switch to one of these funds solely based on this blog. In fact, depending on your situation, there might be better alternatives. For example, my super has been invested using a wrap platform for almost 20 years and I use this for most of my clients also.Avoid indexed optionsIf you have been reading this blog for a while, you will know that I’m a huge fan of low-cost, evidence-based and rules-based share investment methodologies (such as indexing). Therefore, it is probably reasonable for you to assume that I would prefer industry super fund index investment option. However, I don’t.The table below sets out the performance of the longest running index investment options provided by Hostplus and AustralianSuper.See table here. You will note that these index options have underperformed over various periods of time (remember, these returns are after investment fees).American novelist, Upton Sinclair wrote that “It is difficult to get a man to understand something, when his salary depends on his not understanding it”. If the index investment options were hugely successful, industry funds would not need anywhere near the number of investment staff.Firstly, it is therefore not in the investment team’s interest to promote or improve the performance of the index option. Secondly, industry super funds have close ties with unions, and they are typically not in favour of redundancies. As such, it is my view that non-index options will probably continue to outperform.What is the best investment option?Many super funds provide members with two options. The first option is a pre-mixed investment option such as Balanced or Growth. The second option allows you to formulate your own asset allocation by determining how much you would like to invest in Australian shares, international shares, property, bonds and so on.It is my view that you should outsource this important asset allocation decision to investment professionals. Not only do they have the requisite skill and experience to make better-informed decisions, but they will review it regularly and make changes, as necessary.The right super fund will make a massive differenceIt cannot be underestimated how important it is to ensure your super is invested astutely as well as ensuring you minimise investment and administration fees. The compounding impact of optimising this over many years (and decades) is substantial.

2021 super returns: The best industry funds & important considerations

One of the challenges that many investors face is deciding what to invest in, how much and when. There are three methodologies that you can employ to help make this decision, but only two are supported by evidence.What is mean reversion?Mean reversion is a financial theory that suggests a period of above average returns is often followed by a period of below average returns, such that the average return over both periods is close to an asset class’ long term mean (or average) return.Many academics have studied mean reversion and concluded it is an observable and repeatable trend in financial markets.Mean reversion makes sense. It is unlikely that an asset class can generated above average returns for an unlimited period of time. For example, the S&P500 index (US market) has returned over 15% p.a. over the past 12 years. Its long term mean return is close to 10% p.a. Therefore, the probability of it delivering that return again over the next 10 years (thereby generating a return over 15% p.a. over a 20-year period) is very low. In fact, modelling suggests the probability of that occurring is less than 1%.Examples of how perspective & mean reversion helps with investment decisionsI recall that towards the end of 2011, the AUD/USD exchange rate was close to parity (i.e. $AUD1 = $USD1). This meant that it was a good time to invest in the US market (because Australian dollars was more valuable). However, in the 10 years ended December 2011, the S&P500 index had delivered a return of close to zero. As such, an investor would have been excused for discounting such an investment opportunity, because why would you invest in a market that had delivered a zero return over the past 10 years!? Sure, the exchange rate was favourable, but that alone doesn’t validate the investment.Since the end of 2011, the index has delivered a return over circa 14% p.a. and the Australian currency has fallen 30% (relative to the US), resulting in a total return of circa 18% p.a. Mean reversion together with a low-cost index fund have done most of the heavy lifting.Perhaps the most obvious market at the moment that is likely to benefit from mean reversion is the investment-grade apartment market. As I wrote in this blog last year, investment-grade apartments (in Melbourne in particular) have delivered very little capital growth over the past 10 years. If the trend of mean reversion repeats itself, and it will, it is very likely that we are approaching an 8-10 year period double-digit capital growth. No one knows when the growth period will begin. But 4 to 5 decades of evidence tells us it will begin eventually.Of course, it’s difficult to invest when recent returns have been poorWe are all wiser with hindsight. Looking back at my 2011 US share market investment example above, it seems like a no brainer today. However, at the time, it wasn’t. Its counter-intuitive to invest in markets that haven’t performed in recent years. It often feels less risky to invest opportunities that are currently most popular i.e. follow the herd. But it’s not. Astute investing requires discipline and courage.It’s much easier to pick medium-term (or longer) trendsI wrote last week that it’s very tempting to focus on investing opportunities that promise quick returns. However, as the illustration below highlights, it is a highly speculative approach. A far superior approach is to invest primarily using a very long-term lens. This invites you to focus almost entirely on (1) only adopting evidenced-based methodologies and (2) focusing on investing in the highest quality assets. It helps you drown out unhelpful noise.See hereHowever, if your risk appetite permits, you might like to use a combination of medium and longer term approaches. For example, if a client’s investment strategy includes investing in both property and shares, we might adopt the following approach:1. When investing in property, we’ll use a pure long-term approach. Because property is a lump asset i.e. you must invest a large amount, it’s important to take the lowest-risk approach; and2. When progressively invest in shares, we might first invest in the geographical markets and/or sub-asset classes that exhibit the best opportunities for delivering above-average returns in the medium term. That is, relying on the trend of mean reversion.Have cash but don’t know when to invest it?Low interest rates can create a sense of urgency for some investors. That’s because leaving your money in cash rewards you with very little interest (term deposit rates are less than 1% p.a. and mortgage offsets save you maybe 3% p.a.). Consequently, some investors feel compelled to invest their money elsewhere.Alternatively, some investors are concerned that property and share markets are trading close to all-time highs, and don’t feel confident investing in case the market crashes.However, whether to invest or not is rarely an all-or-nothing decision. That is, it’s unlikely the right response is to invest nothing at all and leave your money in cash. But, by the same token, it’s probably foolish to invest all your money tomorrow. Instead, often the most prudent response lies somewhere in between.If all else fails, go long termAs I have written ad nauseam, the lowest risk approach is to focus on the long term. Invest in a way that will maximise your wealth 20 years from now, close your eyes and have faith. As long as you’ve made a fundamentally sound investment, this is sure to be the lowest stress approach to investing.

How you can use mean reversion to drive investment returns

There are a number of factors that I consider when contemplating an investment on behalf of my clients or for me, personally.I think it’s very important to consider a vast array of investment opportunities (or appoint an advisor to do it on your behalf). But it is even more important to discount most of them. Being diligent, setting a high bar and having the discipline to stick to sound fundamentals is critical for success.This blog sets out the important factors that I always consider.Will it materially improve your financial position 10 years from now?It is often tempting to invest in ideas or opportunities that may promise to provide quick investment returns. Doing so appeals to our desire for instant gratification (reward). One of my favourite quotes is from Howard Schultz (billionaire and founder of Starbucks); “short term profit rarely creates long term value”. It’s very true.A quick profit is nice, but it’s not the solution to building long-term wealth, unless you can consistently pick the next short term opportunity. But that is impossible to do. The problem is these ‘quick profit’ opportunities tend to be inherently risky (so many don’t work out well) and provide a one-time return only.Instead, you are much better off to invest in assets that provide predictable returns over very long periods of time. Investing in an asset that provides an average return of 7% p.a. over the next 30 years will magnify its value by 7.6 times.Asking yourself whether the investment you are considering will materially improve your financial position in 10 years’ time, forces you to think long-term. It helps you avoid the shiny objects (i.e. opportunities that trick you into believing they’ll deliver quick profits).Ironically, the older we become, the easier we find it to make long-term decisions. Or maybe we just get more comfortable with delayed gratification. Either way, it requires discipline and patience.Do you understand what’s driving the expected returns?Don’t invest in anything you don’t understand.You need to understand how the investment will work. How will the returns be generated? It must make sense.For example, if you are investing in a property in a blue-chip and highly sort after location, it is easy to understand how that property will be worth a lot more in 30 years from now. How much more is uncertain, of course. But it stands to reason that its likely to outperform the “average” property.However, for example, this is my problem with Bitcoin. I understand what it “could” be used for. I understand the advantages of a decentralised currency that offers privacy (anonymity). But the reality is that the vast majority of people currently buying Bitcoin are doing so for pure speculative purposes. Therefore, the only way I can make a return is if it attracts an increasing number of speculators. And that feels very risky to me. I invest. I do not speculate.All fundamentally sound investments can be explained in simple terms using basic logic. It’s important that you understand this logic. If you are not able to do that, don’t invest.Where is the evidence?There is no need to throw darts at a dartboard. There are plenty of investment opportunities (asset classes and investment methodologies) that offer good long-term returns of 8-10% p.a., which are supported by an overwhelming body of evidence.Therefore, when contemplating an investment, ask yourself where is the evidence that this is going to work. The fact is that such evidence doesn’t exist for poor quality investments. Therefore, following this rule will help you avoid investing in something that won’t work.Of course, only using evidenced-based strategies doesn’t eliminate all risk. It is possible that past returns are not a reliable indicator of future returns, which is why you must take into account the other factors listed in this blog.Who’s making money and how much?Virtually no one promotes investments for free. Often, there’s a commercial incentive to do so. It is very important that you understand what incentives exist, who benefits and by how much. The reason is because you, the investor, ultimately ends up paying for them (through lower returns or lost value).For example, some property developers pay massive commissions (often tens of thousands of dollars) to people that sell/recommend off-the-plan properties to their clients. When the developer sets the property’s sale price, they include the cost of paying commissions. But you (the owner) don’t receive any value for paying them. Ultimately, you’re the one that is out of pocket.Commercial interests aren’t bad per se. People should be fairly rewarded for their time and expertise. And you must fully understand who gets paid what, so that you can make this assessment of whether its reasonable or not and what value it’s going to create for you.What could go wrong?I find most investors focus on possible returns but fail to consider risks. Instead, I prefer to initially identify all the things that could go wrong and think about ways I can reduce or eliminate these risks. I do that before I consider what returns are achievable.As Warren Buffett advises, the first rule of investing is to never lose money. Therefore, by thinking about your downsides first, and mitigating them as much as possible, you might be able to achieve good investment returns whilst taking very little risk. This is the real genius to investing well because normally you have to accept higher risk if you want to achieve higher returns. But that is not always true. Focusing on your downside first goes a long way to reducing your risk, thereby helping you to never lose money.It takes real discipline to do nothingGlobal fund manager, Fidelity undertook a study of the performance of client accounts between 2003 and 2013 and found that the best performing accounts were ones that were deemed ‘inactive’ (e.g. people had lost log in details or forgot the account existed). This demonstrates the value of patience (and the fact that our intervention rarely adds value).You need to have the patience to find the right investment opportunities. And then you need to have the patience to hold onto the right investments for the long run. Do that, and you will accumulate a lot of wealth – albeit it may take a couple of decades.If you can’t find the right investment, do nothing. Don’t compromise. Just keep looking.

When to not invest: 5 questions to ask

Each episode lasts between 5 and 15 minutes (as short and succinct as possible) and contains tips, strategies, research, methodology, case studies and ideas to help you build wealth safely and successfully. Stuart Wemyss is a qualified independent financial advisor, accountant, tax agent and licenses mortgage broker allowing him to provide holistic advice. He has authored three books with his latest being Investopoly. (Buy your copy here - http://investopoly.com.au/). Stuart writes a weekly blog which is reproduced on this podcast

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Investopoly

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