You wanted shares to buy last year but didn’t get around to it, then prices rose and so you were waiting until prices fell, but now that they have fallen you are worried they will fall further.
I have good news and bad news for you.The bad news is as a ‘Nervous Investor’, you will never find a perfect time to invest, when everyone agrees markets are going to go up. The good news is I think I can help.
Let’s look at why retail investors often under-perform, what assets are available and five tips on what to do.
Why retail investors under-perform professionals
Morningstar regularly publishes studies showing retail investors under-perform by around 2% (and others think the gap is larger):
Figure 1: Returns gap
The main factor is behaviour. When markets wobble, investors tend to sell or sit on their cash. When markets have been performing well, investors tend to invest their cash. From a risk perspective, this might seem reasonable to the Nervous Investor – buy when risks seem low and sell when risks seem high. But, from a return perspective, it is exactly the wrong strategy: buy high, and then sell low.
Your brain is actively working against you. The average Nervous Investor makes poor investment decisions in the heat of the moment.
Getting perspective is difficult, especially if you rely on newspapers, financial TV or stock brokers. The first two are in the entertainment business and so creating an exciting story trumps any obligation to give you a realistic perspective. Stockbrokers make money from turnover, so convincing you to buy one day and sell a few weeks later trumps the obligation to give you long-term advice.
Some of the many biases include:
To overcome these biases, create a plan and stick to it.
One of the most dangerous biases is judging a past decision by the outcome instead of the quality of the decision at the time it was made, given what was known. Humans are constantly rewriting history, such as these two staples of investment prediction:
The reality is, investing is never risk-less and there are always reasons for markets to fall or to rise.
Typical assets, and how they usually perform
First, you want to diversify to smooth your returns. Consider the apocryphal portfolio owning an umbrella seller and a sunscreen seller. Some days one does well, other days the other does well. An investment in only one gives a volatile return, an investment in both smooths the return:
Figure 2: How diversification works
The four traditional asset classes are:
1. Cash/term deposits: the big advantage of cash is the value doesn’t fall in times of stress. The disadvantages are that cash gives a poor return relative to other assets, and in times of trouble, central banks cut interest rates which flow through income immediately. If you are relying on interest payments for living expenses, then this can create problems at the worst possible point of the economic cycle. While you can mitigate somewhat by term deposits, you then lose the liquidity of cash. The danger is you own too much.
2. Government bonds: The big advantage of government bonds is in times of stress the value often (but not always, depending on the type of crisis) rises. This provides diversification and income when you want it most. The main downside is the value of the bond does change, and so bonds are riskier than cash. Over the long term, bonds perform better than cash, but not as well as stocks.
3. Corporate bonds: Corporate bonds provide a higher interest rate than government bonds. The downside is there is a much larger chance the company you are investing in goes broke, which manifests itself as a poorer level of diversification. This makes the returns for corporate debt more similar to stock market returns – meaning for the Nervous Investor corporate debt is less useful.
4. Stocks: Stocks are the most volatile – in boom times they return the most, in bust times lose the most. Over the long term they return the most. As a Nervous Investor you want to have a diversified weighting to stocks over the long term, but keep this exposure to a level you feel comfortable with.
Five areas of focus for the Nervous Investor
1. Asset allocation
Get your strategy right and then stick to it. Write it down. Put it somewhere safe and refer to it before you make any investments. As a Nervous Investor, don’t let your emotions rule.
Diversify. Diversify. Diversify. Useful for ordinary investors, doubly so for a Nervous Investor.
2. Regret minimisation
Realise every investor is wrong at some stage. Your goal as an investor is not to make zero mistakes, it is to make sure mistakes don’t ruin your overall portfolio.
First, evaluate the fear versus greed trade-off. If you really want to be the person at the BBQ talking about how much you made on the stock market, then you must take risks. And some years you will have big losses. For many Nervous Investors, this is unrealistic. Abandon your dreams of being the hare and embrace the role of the tortoise.
Second, don’t invest all at once. Make a plan, and for some this will mean gradually investing over a few months, for others, it will mean gradually investing over a few years. You will be alternatively kicking yourself for not investing earlier and then berating yourself for not waiting for the market to fall. Accept that now and move on.
Do you have the knowledge to make investment decisions? If not, get a professional to do it. If you “just need to read up on a few more things”, then get a professional to do it for you in the meantime, in case it takes you a few years longer than you expect.
Do you have the temperament to make investment timing decisions? If not, get a professional to do it. You need to stick to your plan as a Nervous Investor, and if you are unsure of your ability, leave it to the professionals.
Rebalance regularly. As a Nervous Investor, this will be a painful process because it will entail selling assets that are doing well and buying assets that have done poorly. Do it anyway. For many investors, near the end of the tax year is a good time.
Don’t watch every market tick. Once your plan is set up and running, turn off the live prices and financial news. As a Nervous Investor, they are going to pander to your worst instincts.
5. Analysis paralysis
As a Nervous Investor, you are probably already a few years overdue to do something. A longer-term plan might take years to be fully invested if that is what you feel comfortable with. But start now and don’t keep making excuses.
Bonds have been an exceptionally rewarding asset class for nearly four decades. They have also proven to be a reliable diversification tool, particularly when deployed with stocks in a so-called ’60/40′ portfolio. But expecting a repeat performance in the decades to come reminds us of the late financial historian Peter L. Bernstein’s comment that: “There is a difference between an optimist and a believer in the tooth fairy.”
As can be seen in the chart below, this extraordinary period of performance has been unusual in the context of longer-term history. Bonds have benefitted from a favourable tailwind that stretches back to the early 1980s. Recently, the tailwind has been reinforced by the unprecedented actions of central banks following the GFC. To avoid a deflationary debt spiral, the Federal Reserve and other major central banks intentionally drove bond yields to historic lows and even into negative territory in some instances, sending bond prices to new highs.
Prospective returns for many bonds now appear limited
In addition to nosebleed prices and rock-bottom yields, the risks embedded in the bond market would appear to be well above average when we observe cuts in taxes and a ramp up in fiscal spending at a time when government debt is already at or near all-time highs. Governments and central banks are desperate to inflate away these debt burdens. Sustained negative real yields imply sustained negative real returns to holders of these nominal assets.
We also ask ourselves: “Who is the marginal buyer of bonds at these yields if central banks are stepping back?” Historically it might have been large governments recycling their enormous current account surpluses. If a country exports more than it imports, it needs to do something with the difference, and exporter countries have often been major buyers of importers’ bonds. But the reduction of international trade imbalances is now top of the political agenda.
In addition to political will, there are forces at work that should lead to a more natural reduction of the global gross trade surplus. Examples include the seismic shifts in China, where supply-side reforms have the potential to substantially boost imports, and in the US, where the shale oil and gas revolution is beginning to impact the export picture.
The bond sell-off that spooked investors in February this year was driven by greater-than-expected wage growth in the US. It could be a sign of more volatility to come. Negative returns are likely if interest rates continue to rise as quantitative easing begins to unwind. When yields are low, bond prices become extra sensitive to any change in yield, adding a layer of risk.
Rise in correlation reduces diversification benefits
Worse, there are signs that stocks and bonds are now moving together, negating the diversification benefit bonds are expected to provide. Taking a longer-term view of history, the following chart shows that the strong anti-correlation between US stocks and bonds (the negative numbers) since the late 1990s is quite unusual. History suggests that investors should expect bonds and stocks to be more correlated in the future with the possibility of high correlations in a rising interest rate environment. It also suggests that investors might question the traditional diversification role played by long-dated government bonds in a balanced portfolio.
Yields for long-term government bonds can be broken into a few components: inflation expectations, the expected path of real interest rates and the term premium. This latter component can be thought of as the compensation offered to investors for taking on a long-dated risk. It should always be positive, but today, term premiums in most developed markets are near zero, and some, astonishingly, are negative. A negative term premium implies that investors are paying for the privilege of taking on term risk. This is highly unusual, if not nonsensical. Yields can be low for good reasons, but it’s hard to imagine a good reason for the term premium to be negative. This looks like a real inefficiency — a mispricing.
One culprit is quantitative easing (QE), the process where central banks buy bonds and other assets using newly-printed money. Large price-insensitive buyers of government bonds are bound to create price distortions. In this environment it makes sense for governments and companies to borrow long term, and this is what we have seen. Ireland and Austria have issued bonds that mature in 100 years.
Today’s prices force a rethink
One definition of risk is that “more things can happen than will happen”, and purchasers of these bonds have 100 years’ worth of potential surprises to look forward to. For taking on this enormously long-dated risk, investors receive a paltry 2% per annum. Relying solely on long-term government bonds to manage risk at today’s prices strikes us as imprudent at best.
Whenever I make a speech to retirees, I talk about the death tax of 15% (or 17% when it includes the Medicare levy), which can apply to superannuation death benefits. Most people have never heard of it, and believe that Australia doesn’t have death duties.
Well, I guess it is not, strictly speaking, a ‘death duty’, but the effect is the same. So take the time to get your head around it, as it’s an easy tax to minimise with a bit of planning.
The first thing to understand is that it applies only to the taxable portion of your superannuation fund that is given to a non-dependant. A spouse is always a dependant whether they have a separate income or not.
It does not apply to the tax-free portion of your super, so those over 60 and still eligible to contribute to super could take advice about adopting a withdrawal and re-contribution strategy. This involves taking out a chunk of your super tax-free, and then contributing it back as a non-concessional contribution.
There is no cost involved, as there is no entry tax on these contributions, and it effectively converts the amount re-contributed into a tax-free component. But watch the contribution limits as there are big penalties for exceeding the caps.
The next thing to understand is that you cannot elect to withdraw just from the taxable component. If your balance is partly taxable and partly non-taxable, the components of the withdrawal will be in the same ratio as your existing balance.
Many retirees are in pension phase, which means the earnings on their fund are tax-free, as are the withdrawals if they are aged 60 or over and eligible to withdraw. However, the tax-free status of the fund does not mean that all the components become tax-free as well. There will almost certainly still be taxable and non-taxable portions of the components, with the death tax applying to the taxable component when paid to a non-dependant.
One reader asked if the death tax could be avoided by leaving the money to a charity. There is no joy here, as a charity is treated in the same way as a non-dependent. A much better option for anybody who wants to leave money to charity would be to withdraw it from superannuation before they die, make an immediate donation and claim a tax deduction.
However, if you are receiving Centrelink benefits, take advice before doing this, because the gift could be regarded as a deprived asset if it is over $10,000.
So, if the tax does apply, how is it calculated? It is a maximum of 17%, not a flat 17%, and is deducted by your superannuation fund before paying your beneficiary the death benefit. The tax paid is recorded on a PAYG payment summary (similar to wages). When your beneficiary lodges their personal tax return, the assessable amount received and PAYG withheld must be reported. If they have a high income, or if the sum is large, the tax is rebated so that no more than 17% is payable. If they have a low income, they may receive a refund of the tax paid by your super fund.
If you are considering a binding nomination, make sure you clearly understand the implications before setting it up. Once a valid binding nomination is in place, the trustee may lose the discretion to distribute the proceeds of the deceased’s superannuation fund in the most tax-effective manner.
The simplest way to avoid the death tax is to make sure you have given a trusted person an enduring power of attorney, with instructions to withdraw your superannuation in full if it appears that death is imminent. There would be no tax on the withdrawal, and the money could then be distributed in accordance with the terms of your will after your death..
For privacy reasons I will name her Sandra. Sandra said that, following the advice of her “trusted” accountant, she will allow this policy to lapse as her circumstances have now changed
What were her new circumstances? Very sadly, her husband had been diagnosed with a terminal brain illness. What was the accountant’s advice? To allow her Income Protection policy to lapse and redirect the “saved premiums” to mortgage repayments.
On several levels, the accountant has not acted in the best interests of his own client, Sandra.
The above scenario happens all too often. Consequently, the following points need to be kept in mind before acting on any such advice:
So, in summary, when you share your financial circumstances seeking advice, you need to speak to an expert in that area, ensure the expert knows the full details of your circumstances, and that any advice is in your best interests.
For an appointment with a qualified Wealth Adviser, contact us at email@example.com or phone at 1300 761 669 for financial consultation.
There are lots of reasons people give for not buying life insurance, but top of the list is invariably cost. Sounds reasonable enough, especially when households are under pressure from increases in the cost of living. But dig a little deeper and it turns out the way we weigh up decisions when outcomes are uncertain is not always in our best interests.
According to something called Prospect Theory, people fear a certain loss more than they value a larger but uncertain gain.[ii] We tend to view money spent on insurance premiums as a loss, unlike money spent on a daily cup of coffee, a pair of shoes or a weekend away, which deliver immediate rewards.
There’s also a disconnect between what we say we value and what we spend our money on.
Thinking about the unthinkable
Although it is uncomfortable facing the thought of not being there for your family, the real value of life insurance is that it buys peace of mind that if we die or become seriously ill and are unable to work then the right amount of money will go to the right people when they need it most.
Types of life insurance
There are three main types of life insurance. Death cover provides a lump sum if you die or are diagnosed with a terminal illness; total and permanent disability (TPD) pays a lump sum if you are permanently disabled due to an accident or illness and unable to work; and Income Protection provides a monthly payment if you can’t work for a period of time due to illness or injury.
The amount of life insurance you need depends on your family circumstances, your income and lifestyle. While many working Australians have default cover in their super fund, that’s no cause for complacency. It’s often a basic level of cover which may need to be topped up either inside or outside super.
Take Chris, aged 30. He has a partner, two children and the median level of default life insurance cover in super for someone his age. That is, $211,000 in death cover, $162,500 for TPD and $2,250 a month for income protection.[iv] According to a recent report by Rice Warner, the amount someone in Chris’s position needs is closer to $704,000 of death cover, $910,000 of TPD cover and $4,150 a month of income protection.[v]
Paying for a peace of mind
Paying life insurance premiums won’t provide the instant pleasure hit of an espresso, but most people would be surprised to know that the peace of mind that comes from protecting their family’s financial security costs less than their daily cup of coffee.
Rice Warner estimates the cost of death of and TPD cover for the average working Australian at less than 1 per cent of salary, and less than 0.5 per cent for white collar workers.[vi] Which begs the question, what cost do you put on the wellbeing of the people you love most?
If you would like us to help you work out the appropriate level of life insurance for your family, and the best way to achieve it, give us a call.
As we move through life, find a partner, raise a family, and maybe start a business, the importance of insurance in a long term plan increases. That’s because insurance is all about providing a financial safety net that helps you to take care of yourself and those you love when you need it most.
Here are 5 reasons why insurance matters.
Your family depend on your financial support to enjoy a decent standard of living, which is why insurance is especially important once you start a family. It means the people who matter most in your life may be protected from financial hardship if the unexpected happens.
None of us know what lies around the corner. Unforeseen tragedies such as illness, injury or permanent disability, even death – can leave you and your family facing tremendous emotional stress, and even grief. With insurance in place, you or your family’s financial stress will be reduced, and you can focus on recovery and rebuilding your lives.
No matter what your financial position is today, an unexpected event can see it all unravel very quickly. Insurance offers a payout so that if there is an unforeseen event you and your family can hopefully continue to move forward.
No amount of money can replace your health and wellbeing – or the role you play in your family. But you can at least have peace of mind knowing that if anything happened to you, your family’s financial security is assisted by insurance.
A lump sum death benefit can secure the financial future for your children and protect their standard of living.
To ensure you’ve got the right cover for you and your family, please contact us today.