By Jenée Tibshraeny
Small time investors, I recently had a discussion at a dinner party that might interest you.
My 30-year-old friend (who we will call Hamish) proudly shared the fact he had started earning enough that he could afford to invest decent portions of his monthly income.
His plan was to keep minimal cash in the bank and invest large portions of his income in three Smartshares exchange traded funds - NZ Top 50, US 500 and Emerging Market.
Because Hamish doesn’t have any children and isn’t planning to buy a house in the foreseeable future, he was comfortable leaving his money locked up in the share market long term.
He believed he was spreading his risk because he was investing in funds that track the market, rather than individual companies. What’s more, the markets he is tracking are in different parts of the world.
Hamish was aware he had taken a high risk approach, but felt he was diversified enough.
This was when I (figuratively) threw a ‘investing 101’ textbook at him and pointed out his asset allocation was concentrated, so in the event of a global recession, the value of basically his entire portfolio would fall.
If during this time he lost his job, the small amount of cash he had would only cover his living costs for a couple of months, so he would probably have to cash in some of his devalued shares.
But then Hamish raised a good question - how should he diversify?
With interest rates low, he’d only get a measly few percent putting his money in term deposits.
As for the bond market - the minority of people who actually understand how this works, would say that buying bonds when interest rates are low and more likely to rise than fall, isn’t the best idea.
The question then is, should Hamish diversify even if it means investing in an asset at a bad time in the market cycle?
It was at this point I decided to bow out of the conversation and later “phone a friend” - Martin Hawes, authorised financial adviser and Summer Investment Committee chair.
Martin says Hamish is well diversified within an asset class, but needs to diversify across asset classes.
In other words, invest a small portion in bonds and keep some cash.
Martin points out that in the event of a major sharemarket collapse, good quality bonds (government and municipal bonds) are likely to increase in value.
Because an economic downturn is likely to see interest rates fall, bond yields will look relatively more attractive. The demand for bonds will therefore go up, as will their values.
But what about if interest rates rise - the more probable situation currently facing the global economy?
Bond yields will look relatively less attractive, so their demand and thus their values will fall.
(For more on the relationship between bonds and interest rates, see this page. And here is a cautionary tale about buying long-term bonds with resettable, or floating, interest rates).
So is Hamish best leaving bonds out of the equation for now, allocating a larger portion of his portfolio towards cash instead?
Martin thinks not.
If he was Hamish, he’d allocate a small amount of his portfolio - say 10% - towards bonds.
He points out the value of bonds is that you can earn a taxable capital gain.
Martin believes there is still room for interest rates to fall, so in this scenario you could earn a capital gain you couldn’t earn from a term deposit.
You could get say 3.5% when your term deposit winds up, but then you have to find another term deposit, by which time interest rates might be 2.5%.
However the bond fund you bought into at say $1, is now worth $1.05.
While bonds are seen as relatively lower risk assets, Martin points out the bond market is bigger than the sharemarket globally and more fortunes and have been made and probably lost in the bond market.
How does one buy bonds?
Martin says it’s easier for smaller time investors to invest in a bond fund rather than try to use a broker to buy bonds direct from the issuer.
If their fees aren’t too different, Martin would opt for an actively managed fund over a passively managed or index tracking one.
To get an idea of what New Zealand bonds are on offer, see this page interest.co.nz has put together. Also see this glossary of terms if you need a hand deciphering the language in any product disclosure statements you read when doing your research.
As for the cash part of the equation - I was worried Hamish's bank balance was looking too low relative to the amount he’d invested in shares.
Martin says the rule of thumb is one should keep at least the equivalent of between three and six months of your net income in cash.
He suggests using a risk calculator as a starting point, like this one on the Sorted website to get an idea of what your risk profile is and how you should allocate the assets in your investment portfolio accordingly.
Remember, your risk profile may look different to Hamish’s, so a 10% bond allocation as suggested by Martin, may not be best for you.
23 Comments
"diversify across asset classes"
There are only three asset classes in the article: Shares, Bonds, Cash. You should have also informed Hamish of Gold(precious metals), Bitcoin(cryptocurrency) and Property(private or commercial). One fundamental point of investing is not only wealth building but wealth preservation. Share markets collapse, Bonds default, Cash(deposit) gets Bailed in, Property busts, Crypto bubbles and Gold rocks.
"...doesn’t have any children and isn’t planning to buy a house" Sounds good when your 30! But the unavoidable risk to his 'security' that Hamish is oblivious to is ...aging. The family unit that past generations grew up with, and took for granted, was that families look after each other if it all turns to custard. Who is going to house Hamish if he loses it all? Or feed him if he can't tend to himself at 70? Families aren't for everyone, but they are for most people, and it's not until you don't have one, that the cold hard truth of 'what is security' hits home, no matter how much 'wealth' you have....just ask Jamie ( sorry, James) Packer...
I agree! I was 46 and I thought 'I had it all' when I had my only child, a daughter, hence what I wrote above. I'd spent the previous couple of decades clawing my way up the greasy pole. Nothing prepares you for that moment when you hold your new-borne in your arms for the first time, and realise 'what it's all about' - nothing.
I agree with the advice given by Martin.
I note that your friend is 30.
I think that there is a dangerous perception of people of this age and that perception probably underlined or clouded his/her thinking.
For the past 10 years he/she has lived during a period of the GFC and subsequently a world awash with money resulting from a global printing of money (e.g. US QE) and as such equities and housing have consequently performed very well while interest and bond returns have as a consequence from the abundance of ready money have been comparatively low compared to more historical periods.
We are now in a period that we are largely moving out of the GFC and its consequent of cheap money.
Unfortunately, to your 30 year old friend, the GFC and post period have been the norm and hence their preference for what has been good performance of equities over cash deposits for the past ten years.
Unfortunately, the experience of the past ten years may not likely to be the case for the medium term future, but if that is all you know, then it is hard to think otherwise. .
'In other words, invest a small portion in bonds and keep some cash'
As a long time equity and sometime bond investor, I'd emphasise 'small' and change 'some' to ' right now quite a bit in' cash.
For the last 9 months I've been moving quietly to more defensive positions and accumulating cash. The thought of owning bonds make me come out in shingles just now. It bites when you see some of the equities you've sold continue their bullrun but with the chances of a significant correction increasing by the week, I'm not sure I'd be plunging headlong into equities with a big chunk of my hard earned savings just now.
middleman
I agree with you.
My wife recently sold her rental and she has been defensive putting it into a balanced investment fund (about 60% cash/ bonds and 35% Australasian and international equities).
Love to think equities are going to continue as over the past decade but too many darkish clouds on the horizon. It is so easy for anyone to sit back and flippantly speculate that the bullrun is going to continue, but when it is your hard earned cash on the line, the posibility of an extra few percent is hard to justify with the current potential risk factors.
Will review this in six months or so when a little more becomes apparent about those clouds on the horizon.
P.S Returns over the past six months certainly been better than the rental property without the effort and risks, especially with at best a flat or minimal capital gain in house prices.
printer8. I read with interest a recent int.co article pointing out that the 'cash' component of some kiwisaver default 'balanced' funds is exposed to derivate instruments which could see values plunge in a market wide correction. Hopefully you've established that the cash component of your wife's fund is genuinely in cash and bonds.
So ...if one can learn a thing of two in life, then the first lesson is to watch and learn from the professionals.
Look at what the fund managers are doing at the moment ( or at any given time) .... I will explain
It is well known that over diversification kills the profit and balances out profit and loss in different sectors and classes. So reasonable diversification is healthy. Best diversification is in few hand picked shares of successful companies in different sectors like Property, Tourism, Utilities, Retail, Communication, Commodities, and Manufacturing along with cash and maybe Bonds.
Fund managers change the ratio of cash and cash equivalents as they sense the temperature of the market and where the winds are taking it to - that is something that retail investors cannot master unless they have their ears to the ground all the time , it is a full time job , not a hobby. Hence investing with fund managers would bring better results than investing in ETFs and Index funds ( all in the name of diversification) .... you will pay a fee for that but the returns are well worth it --- many funds are returning better than 10% net ATM in Growth and Dynamic funds much less in Balanced funds which are really for retired and old aged low risk profiled people.
I put a young under 30 guy on this track two years ago and asked him to mimic and invest in the majority of the funds which his reputable KS managers are investing in ... his average returns in Dividends and CG exceeded 12% net pa so far and he owns great companies which will survive a big downturn ... his KS growth account is doing a bit better as they invest o/seas.
My personal experience and returns from shares surpass any property yield by miles atm.
Ecobird, that might be your experience but its not mine. Adding up the average gross rental return pa plus my average equity growth pa (using CV values) from rental properties I purchased in 2005, I have calculated an average 20.8% gross wealth return p.a.on rental assets. This will go down slightly over the next 2-3 years but will carry on increasing from approx 2020 onward. Net rental returns have increased markedly recently as rents have increased. Im not saying that shares are not a good way to go re investing, just putting a bit of realism about returns with rental properties if you do it well and buy the right properties etc. Glad you have done well with shares and i might join you to diversify my equities.
PKchew
Something to think about when you calculate returns.
Say, If I put $100 in an investment (such as a bank bond with interest compounding and paid on maturity) and in ten years it is worth $200.
In the eleventh year; would I consider the return as a percentage on my initial investment of $100, or would I be looking at the return for that year on the current value of $200?
Clearly if I made $10 in that eleventh year, on my initial investment of $100 that is a 10% return which is pretty great.
However, as my current capital is now actually $200, my return is only 5%.
I would argue that the later applies if one is evaluating returns.
A simple example, but one that you need to apply to your rental property.
When you calculate returns on your rental property, make sure that you are calculating the return on the current estimated value of your property. Interest.co indicates that current yields are south of 5% and that is before expenses including, rates, insurance, repairs and maintenance and periods of vacancy.
If you are to apply your returns against the current value of the property, then I suggest that you returns are not going to be "slightly less than previously", rather, on your current capital value of your property your return is going to be considerably far, far far, less.
If you think that your return after expenses on the current value of your property is anything more than 5 to 8% you really have an exceptional investment.
P.S.
Here are some figures for you to play around with assuming flat property prices for Auckland over the past 2.5 years:
Current value of (Auckland) rental: $600,000
So, 20.8% gross return on $600,000 = $124,800p.a.
Lets assume a generous 51 weeks occupancy = $2,447 per week.
Wow! Great rental. You sure the tenants haven't got a P-Lab thingy going? :) :)
Lets look at a 8% net return for you on $600,000 = $48,000
Plus expenses (conservative I think):
Insurance - $1800
Rates - $2,800
R+M - $4,000
Total expenses: $8,600
Total rent to cover 8% return and expenses = $56,600
Assume occupancy of 51 weeks: $1,109 per week.
Are you really even getting this on your $660K rental.?
If you are looking at 16% net return, it works out at $2039/week.
If you have a mortgage then at current interest rates; yes, the rent would be less.
Whatever, would like to see your figures especially for a 20% or slightly less return you mention.
Must be totaling up:
Gross Rent P.A.
Capital Gains since 2005 divided by 13 (number of years).
Hypothetical Example:
Buy rental for $300k in 2005, now worth $750k = $34k p.a. capital gain growth.
Rents for $500 per week, so $26k p.a. rental returns
Total $60k p.a. "wealth" return which = 20% of $300k.
Nzdan
Yes obviously, but neither a sound nor really valid method of evaluating annual returns.
This is a compounding situation and one is only fooling oneself if it is effectively anywhere near a 20% annual return either over the period or especially in the recent couple of years.
A need to try to calculate both an annual compound return and current return - these will be well shy of the 20% claimed.
Yes printer8 you are absolutely correct - need to be realistic and practical on return calculations .. one cannot assume returns percentages over a 13 year old purchase when the property is now worth much much more and certainly an astute investor has borrowed against almost all the equity he had built during the years to invest elsewhere.
e.g. I bought a property for 445K 15 years ago, it is now returning $57980 pa ...so I cannot possibly claim that this property is returning 13% , in fact it is actually returning about 4.46% pa as the current property value is $1.3M
However, a study published in the Herald last year ( which I'm struggling to find now) showed that long term property investment almost returned equal yields to investing in the share market .. the difference was only 5%.
Diversification requires having them both as property helps leveraging other investments and could borrow more against than the value of a share portfolio .." Usually its capital gain is a bit higher than classical shares" , However. nowadays they are almost the same after the LVRs getting close to Margin Call lending limits.
But both will return well overtime ...rent from property and dividends from shares if the money was invested wisely. even better if it was invested in venture companies with bright future like A2 milk and many others.
Who said that property investor do not invest and support productive industries ??
Hi EcoBird
Bottom line is that PKchew has done very, very well over the past 13 years. By holding a property long term he has been very fortunate to especially benefit from the very significant house price inflation of the past 10 years. (Congratulations PKchew)
By calculating what is really is the true return on his investment, however will indicate whether it is worth continuing to hold. Many property investors have cashed up, taken their capital gains, and are currently investing this elsewhere with a similar or better and safer return, believing at least that the property party is over for the medium future at least and in some cases that a price correction could occur.
From PKchew's comments, it seems that he feels the market is going to take off again in 2020 and for this reason his decision to hold is the right one for him.
PKchew
Is that calculation on a leveraged basis or unleveraged basis? Is that the return on your equity deposits or on the gross value of your investment properties. In a period of increasing prices, a return on a leveraged basis should be higher than an unleveraged basis, and making this comparison of returns is comparing apples with oranges.
The best way to compare returns on different asset classes is on an unleveraged basis to obtain a true like for like comparison. Whilst I understand, you are assessing the return on your cash outlay, how you choose to finance the purchase of your assets should be taken out of the equation when assessing the returns on different asset classes on a like for like basis.
Eco Bird. Buffets famously successful 2007 $500K bet that passive investing in S&P500 funds would deliver better results than in an actively managed approach, argues against your advocacy for active fund managers. While he won his bet partly because S&P index investing became so trendy and popular, tracker funds continue to generally outperform or at least match AM funds (but at lower cost) since then, partly because of the ever increasing computer power that supports them and against which human fund managers cannot compete.
But despite this I have most of my overseas holdings with active mangers. Partly because I'm old school and that we are yet to see the relative performance of tracker funds in a really serious correction when their AI decision making mechanisms will trigger mass sell offs, which may not be the best longer term strategy.
Index funds do not use complex AI systems - they just track the index which only requires basic systems. The active managers (particularly the hedge funds) are the ones using AI to try and find an investing edge.
Active managers as a group add no performance but extract a large fee.
I think there's actually a much narrower window for wealth acquisition than your 30 year old friend realises. Don’t miss it. Here are my thoughts for what they're worth.
Become super tight! Don’t waste any money. Live in a share house for as long as you possibly can. At 30 you’ve got at least another 10 years. Become the head tenant so you dictate the rent. While I was in NZ I negotiated with the house owner to do the property management for 3%, paid as a rent reduction. That worked very well for both of us. Once you've minimised your outgoings then maximise your income via promotion etc.
Optimising your finances is not enough though! You need to use leverage to build wealth. I hate to say it but property is the only way IMHO to get a leveraged position, capture someone else’s income, and reap the tax advantages all at the same time. Download GNU cash and do all the accounting yourself. This will give you a greater appreciation of the tax system and provide an extra 600 pa of cashflow. Get as much revolving credit as you can and make it work for you. If you’re really enthusiastic about shares, gold, bitcoin (god help you), P2P or whatever then you can invest with the revolving credit money.
Familarise yourself with the dynamics of property. You must anticipate price rises or falls Try to deduce what drives the market, baby boomer migration, foreign buyers, domestic credit. Property is quite difficult because of the many moving parts. I downloaded Steve Keens financial modelling software Minsky and built a model to see how equity changes as a function of time. This is quite cool because I could simulate rising interest rates, inflation, ring fencing of negative gearing etc. Do you research basically.
Ideally you want a time machine so you can go back to when the baby boomers purchased houses. They had an easy ride by comparison.
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