100% return trading CFDs

I phoned CityIndex today to finalise the details on the account I applied for at the seminar last Thursday. I was then able to login to my account to change to password from the initial default value, and I used BPay to transfer an initial $250 into the account. Because I funded the new account within one week of the seminar, I should get a matching $250 put into my account by CityIndex - an immediate 100% return! Of course you can't immediately withdraw the $250 - you have to make a minimum of 10 trades before you can withdraw the "bonus" $250 six months after opening the account. At least the bonus money will give me a $500 account balance to play with - sufficient to make trades with a required margin of around $100. For an Australian stock or Index with a 5% margin requirement that would mean taking a $2,000 position.

It was interesting to see the the CityIndex application pack included forms for opening a CFD trading account on behalf of a superannuation fund. Although the trust deed of our SMSF is probably broad enough to allow 'investing' in CFDs, I wonder how the trustees (DW and I) could justify trading such highly geared instruments within our investment strategy? Rather than purely speculative day trading CFDs, you'd have to execute a much more considered strategy with controlled risk - possibly pairs trading, commodity stripped investment in mining companies, or some such.

I don't think we'll use CFDs as part of our superannuation investments, but I may do some modelling to see 'what if' you used CFDs as a highly geared way to invest in the stock market index. For example, if you invested half you funds in a high-interest online cash account, and used the other half to invest in index CFDs (buy-and-hold, rather than trading), how would you have fared
over various 10-year periods since the 1970s? CFDs have an implicit interest cost of the overnight cash rate + 2%, so I should be able to get daily data for the AllOrds Index and cash rate since 1970. It will be interesting to see how this strategy would have performed in different market conditions, and the effect of the proportion of total funds invested. To much invested in CFDs would probably see your account wiped out by margin calls, and too little would see your fund return remain close to the cash rate.

Subscribe to Enough Wealth. Copyright 2006-2008

Margin lending dilemma

The end of the financial year is nigh, so it's once again time to decide whether or not to pre-pay the next twelve months interest. The main benefit of doing so is that if it's paid before 30 June the entire amount is deductible in this year's tax return. The other potential benefit of pre-paying the interest is that the interest rate is fixed, rather than being variable if you are paying monthly. There appears to be little chance of an interest rate cut in the next twelve months, but some possibility that the interest rate might increase another 0.25% or 0.50%.

Each of my three margin lenders is offering different interest rates for prepaying twelve months interest. St George margin lending is offering 10.25%, but because we have our home and residential investment property loans with them we are "gold" clients, so I get a 0.25% discount on the interest rate, bringing it down to 10.00%. Yesterday I faxed in the paperwork to fix and prepay the interest on $70,000, which is almost the entire loan balance on this account.

I'll probably also fix and prepay most of the loan balance on my leveraged equities account, but I'll leave about $8,000 at the variable rate so I can reduce the loan balance at any time if I sell off some odd stock lots that were left sitting in this account after some takeover activity. Leveraged Equities usually mails me a prepayment form in early June, so I don't yet know what interest rate is on offer. Hopefully it will also be 10% or less.

My third Australian stock account on margin is with Commonwealth Securities (ComSec). They sent out a prepayment offer last week, but the interest rate on offer is an exorbitant 10.35%! This account has my largest margin loan balance (just over $150,000), so I'll have to phone them and try to negotiate a better rate. If they won't come to the party I'll consider transferring the holdings to my St George margin loan account. I'd rather not have to do so, as it might trigger a capital gains tax liability. It might also be a hassle arranging for the Comsec loan to be paid out if the shares on that account are transferred to my St George margin account.

The higher interest rate charged by ComSec seems even more excessive considering that they don't pay any trailing fees to brokers (as I found out from YourShare when I arranged to get a 50% rebate of trails on my various investment and loan accounts by making them my nominated broker). If I borrow funds from St George rather than ComSec I would get a rebate of trailing fees worth around 0.15% in addition to the interest rate being 10.00% rather than 10.35%

The interest rates on my margin loans have increased from around 8% a year ago, to around 10% today. There's considerable risk that the overall ROI of my stock investments won't exceed 10%pa in the medium term, which would make the use of gearing an ineffective investment strategy. However, most of my Australian stock holdings include considerable unrealised capital gains, so I'm not keen on selling stocks in order to reduce my margin loan balances at this time.

If interest rates drop and margin lending remains a useful investment strategy, I'm hoping to be able to liquidate these holdings gradually during my retirement. Under the current superannuation rules my SMSF pension income won't be taxable and doesn't even have to be included on tax returns. This would (I think) mean that it wouldn't be counted as income when working out the marginal tax rate to be applied to any capital gains realised during retirement. On the other hand, the Rudd government has indicated that they want to include such retirement pension income in some social security calculations, so presumably the data would then be available to the ATO and might end up also affecting capital gains tax calculations.

It's a bit hard trying to make sensible decisions about taxation planning when the rules can change at any time. In fact, some Labor politicians have expressed a desire to do away with the current 50% CGT concession for "long term" capital gains, so holding on to my stocks could end up costing me a lot extra tax in the long run. Perhaps I should hedge my bets by selling off a portion of my Australian stock portfolio and use the proceeds to reduce my margin loan balances. Of course, if I want to do that during the next financial year I can't fix and prepay the entire loan balance. Decisions, decisions...

Subscribe to Enough Wealth. Copyright 2006-2008

Tweaking my Portfolio Benchmark

The first attempt at creating a benchmark for my portfolio performance produced figures that pass the reasonableness test. But the benchmark would better represent my asset mix if I changed it from 50% Australian stocks to 30% Au stocks and 20% International. It still won't be an exact match the my portfolio, but it should be good enough to show if my particular investment choices (eg. specific stocks, particular properties in Sydney) are producing adequate returns for the level of risk associated with those asset classes.

Getting some additional data from the latest CBC FInancial Advisor's Investment Market Review provides the following benchmark:

Benchmark^:
50% - Property (Australian House Prices, Sydney median annual values from REIA)
30% - All Ordinaries Accumulation Index.
20% - MSCI World Shares Ex Australia, Accumulation Index in $A.

Data (Quarterly figures up to 31 Apr 08):

1-year 3-year 5-year
% pa % pa % pa
--------- ---------- ----------
50% Property - Syd 2.70% -0.99% 3.21%
30% All Ords Accum. -4.56% 17.39% 18.40%
20% MSCI World ex Aus. -14.46% 5.24% 5.86%

Overall, ungeared -2.91% 5.77% 8.30%

CPI 4.24% 3.22% 2.80%

Cash rate 7.10% 6.39% 5.99%

Approx Loan int rate 9.10% 8.39% 7.99%

Benchmark (50% LVR) -14.92% 3.15% 8.61%

My Portfolio -5.26% 8.06% 11.46%

Using this benchmark my portfolio performance looks much better! If nothing else, it shows that for a meaningful analysis of fund manager or portfolio performance you need to be referencing a valid benchmark. Of course, unless you're looking at an Index Fund (which attempts to minimise tracking error and fees), there will always be deviations from the benchmark caused by the investment decisions being taken. Hopefully the choices add the returns rather than reduce them. It's all too easy to create a drag on your portfolio performance by "churning" your holdings and adding unnecessary transaction fees.

Subscribe to Enough Wealth. Copyright 2006-2008

Is Savings Rate or Total Return more important in reaching your investment target?

I've recently read a couple of posts discussing whether your investment returns or amount of savings has a bigger impact on your final portfolio value. The analyses provided showed that for periods up to 20 years or so, having a large savings rate ($10K pa instead of $5K pa) had a bigger impact than doubling the ROR from 4% to 8%. My initial response was that this was true looking at a 20 year time frame, but over longer periods the ROR ended up being much more important - especially since your savings become a less and less significant part of your total annual NW increase once your portfolio value grows to 3-4 times your annual salary.

I was looking at a comparison of Moomin's monthly net worth figures since 2003 compared to mine, and found that although his NW had increased eight-fold in the past 5 years while mine had only grown slightly more than two-fold in the same period, our NW had moved almost in parallel over this period:



However, the same monthly dollar change in NW represents a much better performance when you're starting out from $60K than it does starting from $480K ! I then did some quick calculations to compare what average total ROI would be needed to model Moomin's result and mine. It turned out that with the same annual savings rate of $30K my portfolio result can be explained with an average annual ROR of 12% and that of Moomin with the same savings rate and a much higher ROR of 23%!



However, although Moomin appears to be a better investor than I (he definitely takes a more professional approach) the ROR seemed a bit high. So I then had a look at what would be the result of a lower ROR but higher annual savings rate. Using the same $30K annual savings rate and 12% ROR for me, but higher savings rate ($45K) and more modest ROR (15%) for Moomin, I get a chart that appears to model the actual results just as closely (I haven't bothered doing any statistical analysis though):



While I think my annual savings rate averages around $30K pa during this period, I have no idea what Moomin's average savings rate has been - although I'm sure Moom knows exactly what his ROR and savings rate are ;) - so I can't tell which model is more realistic. But the point is that the same results can be obtained (over this short time frame) by EITHER getting a higher ROR OR by boosting the savings rate.

As risk is directly related to ROR, it would appear that boosting your savings rate is a more prudent method for achieving your investment goals. That is, trying to cut expenses and increase income in order to boost your savings is a much more certain route to wealth than shooting for amazing investment returns. However, as your NW becomes much larger than your annual salary it becomes more and more important to attain the maximum investment return commensurate with the level of risk you are comfortable with, and to minimise fees and charges.

Subscribe to Enough Wealth. Copyright 2006-2008

How I plan on saving 50% of investment trailing fees

I'd seen a couple of services advertised that will rebate you part of the trailing fees that many investment products pay to financial planners, insurance and loan brokers. So I recently visited YourShare.com.au and joined up. The service offers an annual rebate of 50% of the trailing fees they get paid if you nominate them as your "fund broker" (70% for trails above $4000pa). I sent in completed nomination forms for my income protection insurance, three margin lending accounts, and various fund investments. I got a confirmation email acknowledging receipt and processing of my forms a few days later, and was advised that a few of the investments didn't actually pay any trail (Timbercorp and Rewards agribusiness investments). Also, Commonwealth Securities doesn't pay a trail on margin loan balances, although the form will still be processed so I receive a 100% rebate of the entry fee on any mutual fund investments I make via Comsec.

This means I should be getting a rebate on the trailing fee paid on my "loss of income" insurance premiums (probably 1%-2% of the amount paid), plus I'll get a around 0.25% of the value of my margin loans with Leveraged Equities and St George Margin lending. The rebate cheque is due each anniversary after joining the service, and will cover all trailing fees received during the year.

Although I'd always known that margin loan interest rates are around 1% higher than variable rate home loans, I hadn't realised that most margin lenders are paying 0.25%-0.35% trail to financial planners! As with most investments, if you invest directly in these products (without going through a financial planner or broker) you don't normally get any of this fee rebated (the investment manager simply pockets the trailing fee). Since I have investment loans of around $220,000 through LE and St George, assigning YourShare as my "broker" for these accounts should generate an annual trailing fee rebate of around $550. Not bad for a few minutes work.

There is at least one other similar trailing fee rebate service available, but although it rebates a larger percentage of trailing fees it also charges an annual fee. This makes it better for investors with a large portfolio, but would be similar (or slightly worse) in my case. Anyhow, once I get the first annual fee rebate cheque I'll be able to tell if the other service would provide a larger rebate, and can change broker nomination on my investments if that is the case.

Subscribe to Enough Wealth. Copyright 2006-2008

It's your money, look after it

In another example of the dangers of "outsourcing" management of your wealth, Australian artist Ken Done is suing his financial advisers for $53 million, claiming he lost three-quarters of his personal fortune through bad advice. The 67-year-old's money was apparently invested in risky loans and investments in little-known companies that failed - including stakes in two soccer teams, a beauty spa and an obscure Maltese biotechnology company.

If, as he claims, he gave instructions specifying that only 20 per cent of his money was to be put into speculative ventures, he may be able to recover some of his lost fortune through legal action. Done alleges he was misled by false accounting entries and that he paid nearly $2 million in fees over six years.

However, it appears unclear how much of the loss was due to advice from his financial advisers and how much could be due to the actions of the accountancy firm and the principal accountant responsible for Mr Done's financial affairs. In any case, it again highlights the fact that you are ultimately responsible for managing your own financial affairs, and you should keep a close eye on the actions taken on your behalf by "hired help".

Copyright Enough Wealth 2007

Why I think it might be time to invest in stocks

Unfortunately I'm already fully invested in stocks, so this is of more interest to those investors who may be thinking about when to reallocate some of their investment portfolio into the stock market. My view is that over the long term the stock market has shown a remarkably consistent trend, as shown in the logarithmic chart of the monthly closing value of the Australian stock markets "All Ordinaries" Index since 1980. Therefore, when "Mr Market" has gone beserk and the market is well above or below the trend is the best time to think about adjusting you portfolio (or rebalancing back to your target allocation).

I've highlighted where the market has temporarily deviated well above the long-term trend (in red), and where it has dropped well below the long-term trend (in green). These, to my mind, represent overbought (mania) and oversold (panic) conditions in the market, and would have been good times to reduce or increase your asset allocation to stocks.

The fact that during 2007 the stock market was in the "red zone" was why I bought some Index Put Options (since I didn't want to sell off some of my stock holdings due to capital gains tax concerns). It's also why I'm kicking myself that I let these options expire in Dec 2007 without making a serious attempt at replacing them with a new series. Being in the "red zone" meant that the chances of a significant market correction or bear market were higher than normal, although the market wasn't as obviously overheated as was the case in 1987.

Today the All Ords is about 25% below it's all time high of 6,873 and has dropped well into the "green zone". To me this suggests the start of a buying opportunity (if I had any spare cash to invest). Of course, there's nothing to say the market won't drop even further before bottoming out - in 1987 the "crash" involved a drop of 36% in the All Ordinaries index. However, since the market wasn't as overvalued in 2007 as it had become in 1987, and the Australian economy is still benefiting from the commodities boom, I don't expect the market to drop much further (then again, this could just be wishful thinking on my part).



Copyright Enough Wealth 2007

What to do about Margin Calls

Some readers probably have borrowed "on margin" to fund part of their stock portfolio. A margin loan is basically a loan secured against the value of the stocks in the margin account. The lender will determine the "margin" applicable to each stock, based on it's perceived volatility and liquidity. For example, a blue chip stock that is slightly less volatile than the overall market and is highly liquid (traded in large volumes each day) might be allocated a margin of 80%, whereas a small, speculative company with low capitalisation and daily market volume might be given a margin of only 40% (or 0%). The concept is basically the same as a home loan, where the lender may fund up to, say, 90% of the purchase price of a house. As stock prices fluctuate more than house, lenders require a larger "deposit" to buy stocks on margin. [note: this is how margin lending works in Australia, the situation in the US is similar, but different, with generally lower margins being allowed by the regulator).

Margin lenders may "freeze" borrowing against a particular stock if their clients have a large overall holding in that stock. A more annoying behaviour is when a margin lender suddenly decides to reduce the margin allotted to a particular stock when it announces bad news - the borrower then gets a double whammy from both the drop in the stock price and the reduced margin value of that stock.

In times when the market volatility has increased and the market is down (such as now), margin lenders may even make across the board reductions in the margin values of stocks. This reduces the risk to the lender that the stocks may be worth less than the amount loaned against them, but it's pretty poor customer service as it can precipitate margin calls when the market is down and therefore force stocks to be sold when the price is down. Although the loans are secured against the stocks, the lender would still be able to pursue any outstanding debt with the customer, so decreasing margins when the market gets choppy seems too self-serving.

The ratio of the total margin loan balance to the margin value of the stocks in the margin loan account is known as the Margin utilisation (MU). Assuming margins don't change, the dreaded "margin call" will occur if the value of the stocks in the margin loan account drops to the extent that the margin loan balance is more than the margin loan value of the stocks (plus a "buffer" allowed by the lender). The "buffer" allowed by each lender varies, but is often around 5%. In that case a margin call would be made if the MU went above 105% at any time during trading.

When a margin call is made, the customer has a short time (say, until 5pm the next business day) to get their MU back below 100%. When a margin call is made - DON'T PANIC! There are number of ways to handle a margin call, in order from best to worst:

1. Add some extra collateral to the loan account. This is done by transferring some other stocks you may have (that haven't been used as collateral for a loan) into the margin loan account. Assuming these stocks have some margin value, this will reduce the ratio of the loan amount (which stays the same) against the margin value of the margin loan account (which you have just increased). You'd have to negotiate this transfer with the margin lender as it wouldn't be completed within the usual margin call time frame. You should also check that there won't be any capital gains tax issues resulting from the transfer (some margin lenders require the stocks to be held by a trust account, which can be deemed a change in beneficial ownership and thus trigger a CGT event). Because this isn't an instant process, you're probably better to transfer any "spare" stocks into your margin loan account if you get close to 100% MU, rather than wait for a margin call to occur.

2. Use some cash to pay off some of the margin loan balance. This has a big impact on MU.

3. Use some cash to buy some more stock within the margin loan account. This may be attractive if you are cashed up when the market drops, as it may be a good buying opportunity. However, it won't have as big an impact on your MU as option #2 as although you've paid 100% cash for the new stock purchases, only 70%-80% of the stock value (their margin value) with count in the calculation of your new MU.

4. Sell some stocks to pay off some of the margin loan balance. This has the same effect as option #2 from the lenders point of view, but you will be selling off stocks that have probably dropped considerably in price. You get to decide which stocks to sell, taking into account your CGT issues and which stocks you feel should be retained and which should be ditched.

5. Do nothing. The lender will sell some of your stocks to achieve option #4 as soon as the time limit for the margin call has passed. As you don't get to decide which stock they sell off you may not like the result.

If you have a margin loan account is always a good idea to borrow less than the maximum permitted. For example, if the overall margin allowed for the stocks in your margin loan account is 70%, you may just borrow 50% of the purchase cost. This would mean your MU is (50/70) = 71.4%, and the value of the stocks in your margin loan account would have to drop by 32% before you'd exceed a MU of 105% and get a margin call.

It's also good to check your current position and keep an eye on your margin utilisation. A quick "what-if" calculation will show you how much further the market would have to drop before you started getting margin calls.

For example, at the present time (after today's massive 5% plunge, coming on top of 12 straight days of market decline) my margin loans are as follows:

Account #1
Loan balance $166,819
Account value $282,307
Margin value $209,126
MU 79.8%

A further decline of 24% in the overall market would probably see me get a margin call on this account.

Account #2
Loan balance $121,129
Account value $315,189
Margin value $153,908
MU 78.7%

A further decline of 27% in the overall market would probably see me get a margin call on this account.

Account #2 has a much lower overall margin value compared to the value of stocks in the account because this account holds the $100,000 worth of IPE shares I recently bought. This stock has been allocated 0% margin by the lender.

Overall, I have margin loans of $287,947 with an account value currently around $445,047. An further drop of around 25% in the stock market would see me get a margin call. By that time my equity in the portfolios would have dropped from $309,548 to around $157,100 -- so I'd be pretty unhappy. However, with the market already 22% off it's recent high, that would mean an overall market plunge of around 42%, so I wouldn't be the only unhappy investor around.

Copyright Enough Wealth 2007

Is it good to buy when the market is bad?

There always appears to be a good reason to avoid the stock market when it's in decline. Unfortunately those good reasons often turn out to be unfounded, just as the 'logic' behind a bubble market is always found to be insubstantial upon later reflection. After all, Nobel-laureate economist Paul Samuelson observed forty years ago that "the stock market had predicted nine of the last four recessions".

There have been numerous studies showing that very few (if any) people successfully time the market using skill and judgement (a few people will always get lucky when they try timing the market, or picking stocks, and usually write a book about it). And many more studies showing that your asset allocation has a much greater impact on your overall results than either timing or stock picking. However, it's always tempting to try to pick the best time to enter and exit the market. After all, it's all to obvious in hindsight when we could have done really, really well if we'd just bought and sold at the "right" times.

The current rapid drop in the Australian stock market of more than 10% made me wonder if this is a good opportunity to buy some more stocks. Although a rapid market drop actually increases the amount of "risk"(market volatility), it seems logical that if stocks were good value at $100 then they're even better value during a "10% off everything!" sale. Of course if something fundamental has changed to make the company less profitable in the future, then it's more of a clearance sale of shop-soiled seconds ;)

In an attempt to decide whether to buy some more stocks at this time I had a look at the past ten years closing price data for the All Ordinaries Index to see if buying when the market is down 10% or more from it's previous high would have been a good strategy. (Even if this back-testing showed a particular strategy was a winner, it doesn't mean that the same will hold true in the next ten years). I calculated the average 1-year, 2-year and 5-year returns for having bought on any day vs. the returns achieved if you'd only bought on days when the market was 10% or more off it's previous closing high.

                           bought any day    bought only when
                                             market down >=10%
average 1-year return      10.68%            1.83%
average 2-year return      21.12%            5.31%
average 5-year return      46.45%            10.60%

So, it appears that (at least during the past ten years) buying into the stock market on a day when it was at least 10% below it's previous high would have been a poor strategy. It would seem that this strategy would have meant you didn't buy during the extended bull run periods, and when the market was down more than 10% it was often entering into a bear market. Although this is a very superficial look at a limited amount of market data, it has somewhat dampened my enthusiasm for increasing my stock investment in the current market.

Copyright Enough Wealth 2007

Do as I say, not as I do

On the 10th of December I posted my thoughts that I'd better replace my expiring Index Put Options with some new 'insurance' against a possible drop in the market. I never got around to doing anything about this, and I've paid the price. With my geared stock portfolio every 1 point drop in the All Ords Index is a paper loss of around $100. Since 10 Dec the Index (XAO) has dropped around 500 points, accounting for around $50,000 decrease in my net worth.



It's no good knowing what you should do, if you then don't do it!

Copyright Enough Wealth 2007

The Tax Planning Benefits of Investing in Stocks

Over time I've come to the conclusion that I'm not the next Warren Buffet, and given the amount of time I spend "researching" my stock picks I'd probably get better returns over time from my investments in low-fee index funds rather than my portfolio of individual stock picks. However, one significant benefit of investing directly in a diversified collections of stock remains -- tax planning. For example, this year my wife is working part-time and is entitled to some Family Tax Benefit payments from the government, provided our overall taxable income isn't too high. I'm salary sacrificing a large amount of pre-tax salary into my superannuation account this year, so our combined taxable income will be below the threshold provided I don't realise too much capital gains from selling some of my stock holdings this financial year.

At the same time, the Australian stock market is looking a bit choppy, so I would like to sell off some of my stock holdings and use the proceeds to reduce the level of gearing I have via my margin loans. By being able to pick and choose which stocks I sell I can control how much capital gain I realise this year. For example, I recently took up my entitlement to 124,000 IPE options at $1.00. Since then they have paid out a dividend of around 5c per share, and, combined with the overall market correction, they are now down to around $0.91. If I sell off these shares I realise a capital loss of around $11,000 which I can use to offset capital gains realised from selling off some other shares that I have owned for a longer period and have gone up considerably in price since I bought them. That way I can realise some cash to reduce my overall margin loan gearing levels without increasing my taxable income this financial year.

If I later decide that I want to reinvest in IPE for the long term, I can always buy back in to IPE at a later date. Given the global credit concerns I may even be able to buy them in a few months time for less than I've sold them for - they currently appear to be in a bit of a down-trend compared to the overall market:



Copyright Enough Wealth 2007

The Millionaire Baby Next Door

Consider baby "John Doe". John's father starts doing some overtime (or a second job) as soon as he finds out John is on the way. When John is born he manages to scrape together $12,000 to invest in a low-cost investment fund. If the fund's total return averages 11% pa, the child's investment returns are taxed at 25%, and inflation averages 2% pa, the real, after-tax, return of the investment would be 7% -- and the investment account will hold just over $1 million (in today's dollars) when baby John turns 65.

Of course very few expectant parents would have a "spare" $12,000 lying around when a baby arrives, few dads would go out and earn an extra $12,000 during the pregnancy, and, if they had the choice, most people would probably put the $12,000 towards baby expenses rather than invest it for 65 years -- but it does show what can be achieved with a fairly modest amount invested for a long period.

If a lump sum of $12,000 is beyond reach (after all, that would require putting aside $33 a day for a year), the same result can be achieved by investing $1,000 each year for ten years (ie. finding an extra $3 a day to invest for the child), provided the investment return is somewhat higher (13% instead of 11%) or if the money was invested in a tax-sheltered account (such as a child superannuation account).

If one did both - investing an initial lump sum of $12,000 and then adding a further $1,000 each year until John Doe turned ten, John's investment would reach $1 million (in today's money) by age 58.

Copyright Enough Wealth 2007

Time to Think about some more Market Insurance

The Australian stock market has been trading sideways in a volatile manner since mid-year. No-one really knows if the US economy will succumb to the credit squeeze caused by the sub-prime lending fiasco, and draw the global economy into a slump, inducing a bear market. Or whether the US economy will scrape by avoiding recession, and the continue strength of the BRIC economies and Asia will push the Australian market to new highs.

Overall, after several years of double digit returns, I feel it's prudent to reduce my level of gearing from around 60% overall, to a lower level, perhaps even ungeared. However, I don't want to realise any capital gains this financial year (ie. prior to 30 June), so I need to look at some form of insurance against major losses if there is a significant fall in the market before I sell some stocks and reduce my margin loans.

I bought 7 All Ords Index Put options back in June, which would have offset most of my portfolio losses if the market index dropped below 6,500, but the options expire this month. I could buy some similar options that would offset any significant drop in the market (say, more than 10%), for a cost around 2% of my portfolio value. There are other avenues such a warrants, or even using CDFs to short-sell an ETF such as the Commonwealth Diversified Share Fund. I'll have to crunch some numbers to see which how much each alternative would cost to provide similar protection. These choices also have different features. For example, once I've bought XAO put options they would remain 'in force' until the expiry date. If the market rose they would simply decline in value. In contrast, if I sold CDF CFDs and the stock price rose I'd soon face a margin call to keep the position open.

On the other hand, I don't really believe in "market timing", and my investment plan is to remain invested for the long term and to use gearing to (hopefully) produce improved returns (at higher risk) over my investment timeframe. It's just that the series of interest rate hikes over the past few years have raised the interest rate on my margin loans to around 9.5%, which makes it less likely to be a worthwhile strategy (given the long-term overall returns from the Australian stock market are around 9-12% pa). Also, the recent changes in superannuation rules and the ability to invest in CFDs within the tax-advantaged superannuation system, make it attractive to move funds out of geared direct stock investments and into my SMSF. Using negative gearing (outside of the superannuation system) still provides some attractions via the ability to reduce taxable income and "convert" it into long-term capital gains. This is more beneficial than it might appear from simply looking at the income tax rates, as lower taxable income will impact on capital gains tax rates, access to the superannuation co-contribution for undeducted contributions and eligibility to Family Tax Benefit.

Copyright Enough Wealth 2007

The Role of Luck in Investing

Just as all the children in Lake Wobegone were above average, most investors would like to think that they can achieve above average results - if not now, then in the near future when they have learned the "secret" of successful investing.

In my case I started out buying my first stock investments via a full service broker (in those days there weren't any discount brokers and the Internet wasn't invented yet), generally picking one or two based on avid reading of the stock tips provided in the brokers in house "research" newsletters. After a while I noticed that the broker only seemed to advise stocks to buy and wasn't very good at telling you when to sell a stock (many years later I learned that a "hold" or "underperform" recommendation was code to get out of a stock, and that brokers had a vested interest in giving mostly buy recommendations), so I paid for a subscription to an investor newsletter that advertised impressive returns in recent years. After a while I realised that it was impossible for a small investor to follow all the trades recommended in the newsletter, so you were back to flying solo in terms of picking a few of the recommended stocks. It also turned out that "past performance is not a reliable indicator of future returns" - many newsletters attract subscribers based on a run of good "stock picks" but then fade away when their future selections fail to perform.

The next step as an investor was to read widely and try to learn how to sort the wheat from the chaff for myself. This leads one to fundamental analysis (such as p/e rations, debt ratios, book value and so on), through value investing (looking for good stocks that can be bought for a good price due to being temporarily out of favour), momentum investing (the trend is your friend), contrarian investing (the herd tends to overreact) and variations such as the zulu principle (high peg stocks), technical analysis (charting), and so forth. Some investors will fall in love with one of these approaches, generally because they have some luck with one method or another. While some investors may have the ability, skills and dedication to succeed at one of these approaches, there is great danger that one confuses luck with skill and will continue to pursue a particular strategy when it no longer works. It also turns out that what you read in company reports often isn't all that helpful. Apart from the standard ploys of including graphs of recent annual results if profits and marketshare are increasing, and using tables (or no previous results) and concentrating on "vision" statements when things aren't going so well, the financial figures can be manipulated in many interesting ways. While you may be able to discern the true situation by sifting through all the footnotes to the accounts, it can sometimes be impossible to identify when "creative accounting" is being employed.

Not knowing which, if any, investment approach will work I eventually came to adopt the semi-strong efficient market theory (with some reservations as to it's real world application in times of irrational exuberance or "the madness of crowds"). I tend now to invest with a core of index funds and only the occasional punt on a particular stock that I feel may outperform. Theoretically having a diversified portfolio of 20-30 stocks should eliminate a large amount of the risk associated with attempting to pick individual "winners" and leave you with close to market levels of risk (volatility). However, a recent article by Marcus Padley shows that luck still plays a huge role in how your stock portfolio will perform if you invest in a selection of twenty or so stocks. For example, if your portfolio of 10-20 Australian stocks picked from the ASX200 had happened to exclude BHP Billiton, this year your returns are likely to have been only 7.6% rather than the 13.85% achieved by the ASX200. In fact, excluding the top 10% (the best performing 20 stocks in the ASX200), the return of the remaining 180 stocks was -0.4%! The 20 best-performing stocks in the ASX 200 have averaged a rise of 146 per cent this year, while the 20 bottom-performing stocks have fallen an average of 36 per cent. So in any group of individual investors that pick a handful of stocks for their portfolio out of the ASX200 you would get some that do very, very well and some that do extremely poorly just by pure luck.

Copyright Enough Wealth 2007

Taxation and Wealth Creation

Although taxation should never be the sole deciding factor when making investment decisions (after all it is much better to pay tax on a profitable investment that it is to end up losing money investing in a "tax scheme") it is important to make your investment portfolio as "tax efficient" as possible. The first step is to be aware of just how big an impact taxation can have on your wealth creation plans. Tax rates are suject to legislative risk (that is, they can change unexpectedly when new tax laws come into effect). This can be seen clearly from the change in the taxation situation in Australia over the past 25 years:

                     In 1983       In 2008
Capital Gain Tax     0%            Marginal Tax Rate*
Tax-free threshold   $4,462        $6,000
Lowest Tax Rate      30.67%        15.00%
Highwest Tax Rate    60.00%        45.00%
GST Tax Rate         0%            10%**

One thing that becomes immediately apparent is that the tax system has shifted significantly from direct taxation (income tax) to a more widely-based system of indirect taxation (capital gains and goods and services being taxed).

So, over the long term one can't be sure what tax rates might apply. However, using current tax rates one can see the effect of different tax rates on the return on your investments:

Investment return            8%          10%         12%
After tax @ 15%              6.8%        8.5%        10.2%
less inflation               3%          3%          3%
net real rate of return      3.8%        5.5%        7.2%

Investment return            8%          10%         12%
After tax @ 45%              4.4%        5.5%        6.6%
less inflation               3%          3%          3%
net real rate of return      1.4%        2.5%        3.6%

The true impact becomes even more apparent over the longer term. Just look at the difference in final value of $10,000 invested at 12% with a marginal tax rate of 15% compared with 45%:

Tax Rate applied to returns  15%         45%
Value after 20 years         $40,169     $20,286

This highlights why it is so important to make use of any tax-advantaged investment options, such as investing within a superannuation account.

* a 50% discount if assets disposed of more than 12 months after purchase.
** GST doesn't apply to 'essentials' like unprocessed food, water and financial transactions.

Copyright Enough Wealth 2007

The Early Bird Gets a Bigger Worm

You often see the example of "Dick" and "Jane", the model savers. Jane starts saving $1,000 each year (increasing the amount each year in line with inflation) from ages 21-30 and then stops. Her savings are invested where they achieve a "real"(after inflation) return of 6%. When Jane reaches age 65 she finds that the $10,000 she invested has grown to over $100,000 (ignoring any taxes) - the magic of compound interest over a long time.

By comparison, Dick doesn't start saving until he reaches 35, but keeps saving $1,000 each year until he hits 65. In total he pours $30,000 into his savings account, yet his final investment account balance is slightly less than $84,000 even though he saved more than Jane and earned the same rate of return. This is often used as an example of why it is important to start saving as early as possible for retirement...

What I find even more interesting is the case of Baby X, whose parents put $1,000 into an account for their baby at ages 1, 2 and 3. If this investment earns the same real return (6%) as Dick and Jane, it will have grown to $118,000 by the time X hits 65.

The numbers get really impressive if you look at investing $1,000 each year for a kid from ages 1-10. This is one of the reasons I'll keep driving my seven-year-old Ford Festiva for another five years rather than upgrading to a newer model - it makes more sense for me to put $1,000 each year into each child's superannuation account than moving to a newer model car that will lose that much each year in extra depreciation alone. If nothing else it will mean that they won't need to save extra for their retirement and will be in a better position to pay off a home loan.

It's also a good reason to encourage kids to earn some money and contribute into their own superannuation account - they'll get the $1,500 government co-contribution to help them get ahead. The other benefit of saving for kids via a superannuation account is that the earnings are only taxed at 15%, rather than the exhorbitant rates than can apply to kids "unearned income".

Just as an example, saving $1000 pa from ages 1-10, then $1000 plus $1500 co-contribution from ages 11-20, would result in an account balance of around $778,000 by age 65!

Copyright Enough Wealth 2007

The Company Previously Known as Macquarie Film Corporation Limited

After a slow and drawn out demise, the ill-fated Film Investment Corporation I invested in several years ago (last century I think!) has now been fully wound up. I'd previously received some modest dividends from my $5,000 "investment" in the Australian film industry, and this final dividend of $639.87 brings this expensive lesson to a close. I always knew that investing in films was risky, and the 100% up-front tax deduction was only attractive if there was a reasonable chance of getting a decent ROI. The Macquarie FLIC invested part of their funds in several different film projects - in the expectation (faint hope, as it turned out) that diversification would help reduce the risk of such an investment. However, this turned out to be a classic example of how diversification within an asset class can't reduce "market risk". As it happened, the entire Australian film industry produced a string of flops in the years following my investment, so nearly every project the company had invested in lost money.

The only thing I still don't understand is how come, although the wind-up and deregistration of my shares is a "capital gains event", "no capital gain or loss is likely to arise in respect of this event". The letter from the liquidator did say that "Shareholders should seek their own independent taxation advice..." but that is just the standard "don't blame us if we got it wrong" boilerplate. Since I do my own taxes I'll just have to keep an eye out for any relevant comment about the tax implications of this wind-up in the financial press, or maybe I'll write a question to one of the weekend newspaper financial columns. As far as I can tell, just because an investment was tax-deductible doesn't mean that you wouldn't pay capital gains tax if you eventually sold the investment at a profit. On that basis I was expecting my capital loss to be deductible - but what would I know.

Copyright Enough Wealth 2007

Beware of Little Old Ladies who can make you Rich

There have been a few cases recently in Sydney of respected, older women taking advantage of trusting friends and neighbours to defraud large sums of money. The SMH has reported the latest instance where a 65-year-old woman allegedly obtained funds totalling more than $2.6 million by deception. Between 2004 and 2006 numerous people invested money in a "business scheme" with the woman, but when some of the investors requested their money back, the funds were allegedly not returned. It goes to show that you should be very careful when "investing" your hard-earned money with friends or relatives. You obviously would have to have a good opinion of the person's integrity and capability to even consider such as investment, but the truth is that it is almost impossible to make an accurate risk assessment of such an investment.

Copyright Enough Wealth 2007

Eating the Seed Corn

While it's good to look for sources of extra income, especially passive income, counting interest and dividends as part of your disposable income might be a mistake. I choose to only consider my income from salary as 'disposable' and have a savings target based on that income. This is because the income flowing from investment properties, shares and savings accounts forms part of the overall ROI of such investments. If you base your financial plans on the likely (eg. historic) returns of the assets in your investment portfolio, bear in mind that such figures generally assume all dividends or interest are reinvested. If you spend the some of the income being generated by your investment portfolio while it is still in the accumulation phase you will reduce the ROI of your portfolio. Even a small decrease in annual ROI will, over a long period of time, significantly decrease the final value of your portfolio.

Copyright Enough Wealth 2007

Every Cloud has a Silver Lining

The Australian Stock Market dropped another 3% or so today. Since I'm a long-term, high-risk-tolerance investor (supposedly) I should be sitting fully-invested (mostly in stocks) and having to grit my teeth and bear it as the market drops, taking my net worth down with it. But by happy coincidence I'm not as fully invested in the stock market right now as I should be.

A large chunk of my net worth is tied up in two properties (our house and one rental property). Although this has been a drag on my overall investment portfolio performance since the Sydney property market peaked in 2003, this year the property market has started to pick up a bit. The latest monthly sales price data came out today, and the estimated valuations of our two properties have jumped $25,964 and $10,364 respectively.

My margin loan accounts are still fully invested in stocks, but I'd been allowing my gearing level drop from around 70% debt:equity a couple of years ago to recently dip below 50% as the bull market had progressed. This has reduced somewhat the geared effect of the market drop on my stock portfolio equity. At the same time I've had some Index Put Options in place since the start of the year, and the increased value of these as the market drops offsets around 1/3 to 1/2 of the losses on my stock portfolio.

And, most fortuitously, we're in the middle of shifting our retirement accounts from a retail Superannuation fund into our own SMSF. This has meant that our retirement funds are currently either in transit between accounts ("the cheques in the mail") or is sitting in the SMSF bank account awaiting investment. So, if the market keeps dropping before we reinvest in our preferred high-growth asset allocation we could end up getting some benefit from the current market shake-out.

If the market drops another 5% or so in the next week we would end up reinvesting at a discount of around 10% compared to the prices at which we cashed up last week. Of course the market could just as easily bounce back before our funds transfers are completed and we re-invest. But at least at this stage we're in a better position that if the market had been in a strong rally while we were sitting on cash.

Copyright Enough Wealth 2007