I am delighted to publish this guest post from my friend and former colleague Paul McGuire, who has had a diverse career as a professional economist, including positions in the Commonwealth Treasury, OECD, Australian Government ministerial offices and Queensland Government agencies. His career has taken him all around the world, to Paris, the Cook Islands, Canberra and Brisbane, among other places. The views expressed in this article are Paul’s and should not necessarily be attributed to me. GT
Some Investment Tips – dos and don’ts
by Paul McGuire
As an economist I am often asked for investment advice by friends and relatives. Accordingly, I have developed some tips based on my own research in managing my investments and those of my family. They have also benefited from comments and suggestions from a number of friends and colleagues. They are intended to be general information only and do not constitute professional advice.
1. Pay down your loan on your principal place of residence
If you have a home loan, the interest on your home loan is not tax deductible. Hence you are paying your interest from your after tax income.
If you are paying 5% interest on your home loan and your marginal tax rate is 34.5% (i.e. your taxable income is between $37,000 and $87,000 from 2016-17), paying down your home loan is equivalent to earning 7.6% before tax from an alternative investment.
If your marginal tax rate is 39% (i.e. your taxable income is between $87,000 and $180,000), paying down your home loan is equivalent to earning 8.2% before tax from an alternative investment.
If you know of a risk-free investment with guaranteed returns above 8.2% per year before tax please let me know and I will gladly invest in it.
You should also see if you can use an offset account for your day-to-day transactions. Any money in the account is offset against your home loan and directly reduces your interest payments.
2. Take advantage of your superannuation concessional contributions cap
There are a lot of tax advantages in investing in superannuation. The advantages are being reduced following the 2016-17 Budget, but the changes will generally only affect high income earners. The taxation treatment of superannuation will remain highly concessional.
- You can make concessional contributions to superannuation through salary sacrifice arrangements up to your concessional contributions cap. These are currently $30,000 per year for those under 50 and $35,000 per year for those aged 50 and over, but will be reduced to $25,000 per year for all persons from 2017-18. Note that the cap includes superannuation contributions made by your employer on your behalf, generally 9.5% of your income.
- Concessional contributions are made from your before-tax income, but are taxed at 15% on entry to the superannuation fund. If your marginal tax rate is 34.5%, this is a saving of 19.5 cents on every dollar. If your marginal tax rate is 39%, it is a saving of 24 cents on every dollar.
- Once your money is in the superannuation fund, the earnings are taxed at a maximum rate of 15%, not at your marginal tax rate as an alternative investment would be.
- And once you retire after 60 or reach 65, you can transfer your superannuation (up to a maximum of $1.6 million) into the retirement phase, where the earnings are tax free and you can withdraw it tax free.
- You have flexibility to choose your superannuation fund and where they invest your money –points 5 to 10 below are relevant in choosing a superannuation fund
3. Consider transition to retirement arrangements
A transition to retirement arrangement enables you to receive regular payments from your superannuation while you are still working. Each financial year you can access up to 10% of the money that was in your superannuation account at the start of the financial year.
You can do this once you’ve reached your preservation age (currently 56 but phasing up to 60), but the tax rules mean there’s not much point until you reach 60 (unless of course you have reduced your working hours and you need the money).
However, if you are over 60 and you’re still working, you can withdraw money from your superannuation account tax free, but still take advantage of your concessional contributions cap. This means that effectively, you can withdraw money from your superannuation account and then get taxation concessions to pay it back in through salary sacrifice arrangements.
This may not suit everyone. But if you are over 60, earning more than $37,000 per year but can’t afford to take full advantage of your concessional contributions tax, it is definitely worth looking at.
4. Consider non-concessional superannuation contributions
If you are under 65 you can also make non-concessional superannuation contributions. These are in addition to your concessional contributions. In 2016-17 the non-concessional cap is $180,000, and you can bring forward two years of non-concessional contributions (i.e. you can make contributions of $540,000 in 2016-17 if you have not already triggered the bring-forward rule. From 2017-18 the non-concessional cap will be reduced to $100,000 per year, and anyone with a superannuation balance of more than $1.6 million will not be able to make any further non-concessional contributions.
Non-concessional contributions are not tax deductible, but are not taxed on entry to the superannuation fund. The advantage is that once they are in the superannuation fund, the earnings are taxed at a maximum of 15% rather than at your marginal tax rate. And once you retire after 60 or reach 65, you can transfer your superannuation (up to a maximum of $1.6 million) into the retirement phase where the earnings are tax free.
5. Understand the “Efficient Markets Hypothesis”
Now it is time to leave superannuation and get a little bit technical for a moment. You can skip over this section if you like, but it will help you to better understand the remainder of this commentary.
The so-called “Efficient Markets Hypothesis” (EMH) claims that prices of traded assets (e.g. shares, bonds, or property) already reflect all current publicly available information. For instance the price of a Coles share reflects everything that is currently known about the company – future demand for its products, its sources of supply, its business strategy, etc. If some new information comes to light, the so-called experts will very quickly take this into account and buy or sell shares in Coles, causing the price to adjust to the new information.
The same goes for other assets like property. The price of apartments in West End reflects everything that is currently known about future construction projects, demographic trends, changes in council regulations, etc.
There is a lot of debate among economists about EMH, and I wouldn’t necessarily subscribe to some of the more extreme variants. But it is a pretty good guide for the average investor. Do you really think you have insights into what is going to happen to the price of Coles shares or West End apartments that the institutional investors and their teams of analysts haven’t already thought of and isn’t already reflected in the price?
If you understand and broadly accept the implications of EMH, investment suddenly becomes a lot easier and you will be able to see through a lot of well-meaning and not so well-meaning advice that you might receive.
6. Don’t try to beat the market
A direct implication of the EMH is that it is impossible to “beat the market” consistently on a risk-adjusted basis. I don’t know if the price of Coles shares or West End apartments is going to rise faster than the market average. More importantly, despite the media hype and barrage of views from so-called experts, neither does anyone else. If you try to beat the market, the law of averages says that sometimes you will succeed – and sometimes you won’t. And if you do it is because you’ve been lucky, not because you’re clever.
7. Invest for the long term
What goes for individual shares and properties goes for the market as a whole. Nobody knows what will happen to the stock market or the property market over the next three months or the next twelve months. The EMH tells us that if they did, it would have happened already. So there’s no point in shifting your assets between shares and property and cash in line with expected market conditions. You may be lucky and pick the turning points – or you may not. Choose a long term investment strategy and stick to it.
8. Understand the trade-off between risk and potential return
Generally speaking, the higher the potential return on an asset, the greater the risk. The table below shows this trade-off for the most common asset classes.
|Asset class||Examples||Risk||Potential return||20 years to 2015 (Australia)|
|Average return||Negative years|
|Cash||Bank & term deposits||Low||Low||5.1%||0|
|Fixed interest||Government & corporate bonds||Low/ moderate||Moderate||6.8%||1|
|Property||Residential & commercial property||Moderate/ high||Moderate/ high||8.0%||5|
|Equities||Australian & international shares||High||High||8.8%||3|
You need to choose an investment strategy that suits your risk preference and time horizon. For instance, if you have a 20 year time horizon you may wish to focus on assets with a higher risk such as property or equities because you are likely to benefit from the ups as well as the downs. If you are saving to buy a house in 12 months you might want to adopt a more conservative strategy.
There are lots of managed funds where you can purchased a mixed portfolio of assets – e.g. conservative, balanced, growth or high growth – depending on your risk preference.
As noted above there is a trade-off between potential return and risk – if you invest in a broad portfolio of assets.
However, if you invest in a narrow portfolio of assets you may increase your risk without increasing your potential return. For instance, if you put all your money in Coles shares, there is no reason to believe that your return will be higher than if you invest in a portfolio of shares. However, your risk is higher because your investment is wholly dependent on the performance of one company.
It is therefore sensible to diversify, both between asset classes (e.g. shares and property) and within asset classes (e.g. with a broad portfolio of shares). Again, you can build your own portfolio, or you can invest through a managed fund that itself invests in a diversified portfolio. Another alternative is an exchange traded fund, which is similar to a managed fund but is traded on the stock exchange.
There are also advantages in building up your portfolio over time – e.g. by investing a set amount each quarter or each year. This reduces risk as you will not be exposed to market conditions at a particular point in time.
10. Fees matter
Managed funds generally charge an administration fee, sometimes known as a management fee or investment fee. Any other form of investment will also have various transactions and other fees.
Small differences in fees can make a significant difference to your returns as an investor. For instance, assume you have an investment of $200,000 which makes a return of 8% per year before taxes and fees. Using actual data for two prominent fund managers:
- Fund A charges annual fees of 0.55%. This means around 7% of your return goes on fees.
- Fund B charges annual fees of 1.59%. This means around 20% of your return goes in fees.
- After 10 years you would be around $38,000 better off if you invested in Fund A.
Would you get a higher return before taxes and fees by investing in Fund B? Fund B is an actively managed fund with fund managers who try to “beat the market” by predicting which investments will perform well in the future. By contrast, Fund A is an index fund which aims to match the market by holding assets in the same proportions as the broader investment market. This leads to much lower costs.
As discussed above, the EMH suggests that it is not possible to “beat the market” consistently. The evidence suggests that on average, actively managed funds do not out-perform index funds, and indeed do worse after taking account of fees. For the record, over the five years to March 2016, Fund A had an average annual return of 9.08% before taxes and fees, compared to 8.71% for Fund B.
Some managed funds may charge other fees such as establishment fees, contribution fees, performance fees, withdrawal fees, termination fees and switching fees. These need to be factored in to any calculations, and I personally would steer clear of any funds which charge these types of fees.
11. Don’t invest in rental properties
This is probably the most controversial point in this commentary. Many people invest in rental properties, and some have done very well out of them.
However, investment properties are not really consistent with points 8 and 9 above.
If you buy a rental property, your returns are highly dependent on the local property market in that particular location. This increases your risk. However, your expected return is no higher than the market average. Hence you are increasing your risk without increasing your expected return.
If you want to invest in property you can always do it through a managed fund. This gives you the benefit of diversity without making you unduly dependent on one particular location.
There are a couple of exceptions to this rule:
- It may be worth considering a rental property if you can add to its capital value through renovations and improvements. Your labour input is not taxed, and the capital gain is subject to the concessional tax treatment applying to capital gains.
- If you already have a diverse asset portfolio, the lack of diversification is less important than if it is your only investment.
12. Borrowing to invest depends on your risk preference
Should you borrow to invest? The answer depends on your risk preference.
Generally the safest and best way to borrow is against the security of your home. An alternative is to take out a margin loan – e.g. if you borrow money to buy shares, the lender may take the shares you buy with the loan as security. This means the lender can sell the shares to repay the loan. This is riskier and will generally attract a higher interest rate.
As noted above, the average return on Australian shares over the 20 years to 2015 was 8.8%. Over the same period, the standard variable loan interest rate averaged around 7.1%. So if you had borrowed money in 1995 and invested it in shares you would have made a very good profit.
You would also have had significant tax advantages. The interest payments would have been tax deductible. While the return would have been taxable, much of this would have been in the form of capital gains and subject to concessional tax treatment.
On the other hand, if you had borrowed money in 2005 it would have been a very different story. Over the 10 years to 2015, the average return on Australian shares was only 5.7% while the standard variable loan interest rate averaged 6.9%. So you would have made a loss.
In seven of the 20 years, returns on shares were less than the interest rate. Five of these were in the last 10 years.
So if you borrow money to invest in shares or other assets with high potential returns, you will probably make money. But you can easily lose money, even over relatively long periods. It is really up to you and whether you are comfortable with that risk.
13. If it sounds too good to be true, it almost certainly is!
Finally, there are numerous operators promoting various investment schemes promising high rates of return. As should be clear from the points above, don’t even think about them.
To reiterate the EMH, it is impossible to consistently “beat the market” on a risk adjusted basis. Some of these schemes may do alright for a short period while market conditions are good, but this generally does not last very long.
Even if the operators are not deliberately trying to rip you off, such schemes generally fail a number of the tests above. For instance:
- They are generally not diversified but involve investing in one or two (high risk) sectors.
- They generally charge high fees and commissions (which are not transparent). If the operator offers various inducements to join the scheme, remember that they are recovering the cost of these (and probably a lot more) from fees and commissions.
If you are purchasing investment products, always go with reputable firms with established reputations. If an operator makes unsolicited approaches or is pressuring you to invest in a particular product or to make a quick decision, this is a sure sign that the product does not stand up to rigorous analysis.
I have a Bachelor of Commerce with first class honours in economics and a Master of Economics, and considerable experience in developing financial models. However, I have no qualifications in financial advice or financial planning.
This commentary is for general information only and should not be taken as constituting professional advice.
I am not a financial adviser. You should consider seeking independent legal, financial, taxation or other advice to check how this information relates to your stage of life and your unique circumstances.
I am not liable for any loss caused, whether due to negligence or otherwise arising from the use of, or reliance on, this information.
Hi Paul and Gene,
Thanks for this. Two of the simplest pieces of advice – overpaying on your mortgage and super – are very wise.
As a landlord with a house in the UK, I’ve used cash I don’t think I’ll imminently need to make mortgage overpayments. I pay 4.7% on my home loan – that beats getting 0.05% on my savings!
I agree that being a landlord is overrated. There are costs to maintain a property and stresses that tenants bring that don’t apply with other assets.
Thanks for the demonstration of the equity premium puzzle too.
Thanks James, yes using a mortgage offset account for your working capital certainly makes sense. I am a landlord too, so I haven’t always practised what I now preach!
Best advice I ever received is ” don’t take financial advice from people who have less money than you, otherwise it’s just theory, and that’s not a currency anywhere” .
I would be interested in Paul’s thoughts on paying down the mortgage v salary sacrifice into super, I believe the numbers are good for anyone in the 32c tax bracket and for anyone over $80k a year on 40c I think it’s a no brainer particularly with these low interest rates, but so few people seem to look at that option and just focus on paying down the mortgage.
Thanks for the comment Glen. I agree that barring a market crash you would certainly expect the rate of return to be higher on salary sacrificing/ concessional contributions into super. It probably depends a bit on your age and time horizon though as you may not be able to access your savings for a long time.