A classic mistake

A classic mistake

by | Jun 12, 2018 | Financial Planning, Investments, Wealth Management

What would you do: you’re 67 years old and about to retire from General Electric with a company pension. You hold US$1.8 million worth of GE stock, which accounts for 90% of your investment portfolio. Do you sell some of your GE and diversify or sit on it because it’s a blue chip company?

This was a topic discussed on a recent episode of one of my favourite podcasts, called Animal Spirits, where two American financial bloggers chat about things they’ve found interesting over the past week. It was actually a thread on Reddit posted by the retiree’s son, who was asking what his dad should do having held the shares for years and being “quite stubborn”, which presumably means he wanted to hang on to them.

There were some 124 comments on the post. While I haven’t read all of them, my sense is that most were arguing he should keep the shares, with quite a few pointing out the 4% dividend yield would pay him US$72,000 per year. I’ve no idea what the guy ended up doing but, given what’s happened to GE shares in the nine months since, there’s a really good lesson to be had for anybody.

When the original question was posted in September 2017, GE shares were trading at around $24, having fallen about 20% in the previous year and compared with a peak of about $33 in July 2016. GE has been one of the great blue chips of the American market, so it’s not surprising that a lot of people expected it would rebound. Alas, today the stock is trading around US$13.60 after revealing problems with its power generation division, amongst other things, and cutting its dividend in November 2017 – see chart 1.

 

Chart 1: the GE share price has fallen more than 40% since September 2017
Chart 1: the GE share price has fallen more than 40% since September 2017
Source: investing.com

So if the retiree didn’t sell any of his shares, the holding would now be worth just over US$1 million and at the current yield of 3.5% he’d be receiving around US$35,000 in dividends.

So lesson number 1 is concentration risk. This guy had 90% of his investment portfolio tied up in a single stock, which is also the company that’s going to be paying his pension. That’s an awful lot of exposure to have to a single company, blue chip or not.

It’s often said it takes concentrated exposure to get rich, but you diversify to stay rich. While we can all name exceptions to that rule, when you’re that close to retirement the way the equation stacks up is very different to when you’ve got 20-30 years of work ahead of you.

Lesson number 2 is about what’s called ‘sequencing risk’, which is taking a big hit to your assets when you’re not going to be able to make up the lost money through work. He needed to do the sums: his total investments were worth US$2 million, plus he was going to get a pension. Could that amount of money have supported the lifestyle he wanted in retirement? If the answer is yes, then it makes sense to take steps to protect the capital, if it’s no, then how much more money do you need and what’s the best way to get there?

Just as importantly, he needed to ask himself how he would feel if the total of his investments dropped to US$1.8 million, or US$1.6. If the answer is he would have felt pretty miserable and stressed about the future, again, he needed to protect the capital.

When you’re about to retire is not the time to take the attitude of ‘those shares have fallen so far already, surely they won’t fall further’. Any share can go to zero, even those considered to be blue chips, just ask holders of Enron shares. And while of course there may be tax considerations in selling a big holding, it is risky to allow tax to be the main determinant of your investment strategy.

This scenario is yet another example of where our human biases can get in the way of making sensible decisions. It’s also another example of where it can be a good idea to get objective advice.

If only we were more like Sylvia Bloom

If only we were more like Sylvia Bloom

by | Jun 4, 2018 | Financial Planning, Investments, Wealth Management

Sylvia Bloom was a legal secretary in New York who died last month at the age of 96 and left behind a fortune of A$12 million. She’d worked for the same law firm for 67 years and quietly bought shares in companies she overheard her bosses were buying. Her big secret: she never fell victim to the “behaviour gap”.

An instinct to follow the herd has been very handy for human survival over generations, it basically helps prevent us being eaten. However, it’s also why most humans are hard-wired to be poor investors: we get swept up in excitement or panic and end up buying high and selling low. Not surprisingly, studies have shown if you’ve done the research, once you’ve settled on an investment strategy you’re better off sticking to it.

A few weeks ago I wrote a post about Peter Lynch, one of the best fund managers ever, and his investing principles. But Lynch’s employer, Fidelity, calculated that although his Magellan fund returned an astonishing 29% per annum over the 13 years he managed it through to 1990, the average investor in the fund actually lost money! How? Buy buying in when returns had been great and selling when they weren’t.

Likewise, legendary US hedge fund manager, Joel Greenblatt, whose Gotham Capital returned an incredible 40% per annum between 1985-2006, calculated over the period 2000-2010 the best mutual fund delivered 18% per annum, but on a dollar-weighted basis the average investor in the fund lost 11% per annum over the same time. Again, the money poured in when the market was up and disappeared when it fell.

Greenblatt went on to examine the best institutional managers over that 10-year period and found that at some point 97% of the best funds spent at least three of those 10 years in the bottom half of performers; 79% spent at least three out of the 10 years in the bottom quarter, and half spent at least three years in bottom 10%! When the market’s going up and you’re staring at an investment in the bottom 10% it takes real fortitude not to pull the trigger and jump out.

There have been a number of studies looking at “the behaviour gap”, which measures the loss the average investor incurs as a result of emotional responses to market conditions compared to sticking with a strategy – see chart 1. Obviously minus 1.17% to minus 4.3% is a big range, which leaves you wondering how they could come up with such varying results, but the message is consistent: allowing yourself to be captured by the herd mentality can cost you a lot of money. For example, if you start your investment strategy with $100,000 and you could get 7% for 20 years you’d end up with $387,000, reducing that by the median ‘behaviour gap’ you’d end up with a 4.3% per annum return and finish with $231,000!

 

Chart 1: The seven studies below looked at “the behaviour gap”, to assess the annualised reduction in returns the average investor incurs due to emotional responses to market conditions
Chart 1: The seven studies below looked at “the behaviour gap”, to assess the annualised reduction in returns the average investor incurs due to emotional responses to market conditions

There will, of course, be times when it is perfectly justified to sell an investment. We’ve sold out of funds when the manager hasn’t stuck to the original model (something called style drift), or we’ve come across a different manager that we believe quite simply does a better job. But our underlying objective is always to find the best manager for a particular asset class and stick with them. Over the long run it works better that way. 

What happens to my super when I die?

What happens to my super when I die?

by | May 28, 2018 | Financial Planning, Investments, Wealth Management

It’s a question that comes up from time to time, however, it’s one which superfund members should understand as it’s an important consideration for tax purposes when your estate planning strategy is put in place.

So, what does happen with my super when I die? Well, it really depends upon several factors including:

  • Age
  • whether you are in pension or accumulation phase
  • who is considered a ‘dependent’ under both superannuation (SIS) definition and the ATO definition
  • the amount you have in super
  • the ‘taxable’ and ‘non-taxable’ components of your super
  • what your trust deed allows.

Generally, the options on how your benefit can be paid to beneficiaries upon death are:

What happens to my super when I die image1
What happens to my super when I die image1.1

Who is a ‘dependent’ and a ‘non-dependent’?

One thing you need to be aware of is that there are two definitions of who is deemed as a dependent. One relates to the SIS Act (Superannuation) and the other under the ITAA 97 (ATO). This is an important distinction because while a dependent receives the benefit tax free, a non-dependent under the ITAA will incur tax on super benefits.

Under the ITAA, a death benefit paid to a beneficiary will be deemed a ‘dependent’ and therefore will be tax free if it is paid to the deceased’s:

  • spouse;
  • child under the age of 18;
  • any person over 18 years and financially dependent or in an interdependent relationship.

An interdependent relationship is a close personal relationship between two people who live together, where one or both provides for the financial and domestic support, and care of the other. This definition can include parent-child relationships that don’t fall within the usual definition of dependent and can also include sibling relationships.

Any person who does not fit within these categories can only receive the superannuation benefit via the deceased fund member’s estate.

Super Taxation

Superannuation benefits consist of different components for tax purposes:

  • a tax-free component;
  • a taxable component; and possibly
  • an untaxed element of the taxable component.

We have established that if you are a dependent under the ITAA definition, your lump sum benefit will be tax free. However, if you are receiving the super benefit as a pension rather than a lump sum, you may be required to add the taxable component of your pension income to your assessable income. This will depend on your age.

What happens to my super when I die image2.1

However, if you are a non-dependent for tax purposes, the above components will be taxed as follows:

What happens to my super when I die image3

The new transfer balance cap (TBC) and death benefits

From 1st July 2017, the transfer balance cap (TBC) will apply to limit how much a member can have in retirement phase over their lifetime. For 2017/2018 the TBC is $1.6m. When a member dies, their TBC is not transferable to a dependent or even their spouse.

When the deceased member’s superannuation benefits are cashed as a lump sum, there is no impact on anyone’s TBC and the relevant death benefit taxes we previously discussed will apply.

However, if the benefit is used to continue paying a reversionary pension to a spouse, the surviving spouse will need to add its value to his/her super asset balance. This can only be paid as a death benefit pension if it doesn’t cause the dependent to exceed their TBC. Any excess will need to be paid out as a lump sum death benefit and cannot be retained within the super environment.

To reduce any excess and retain it in the superannuation environment, the receiving beneficiary will need to commute their own benefit first as it can still be held in the superannuation environment as an ‘accumulation’ interest. The death benefit pension they receive from the deceased can be retained up to the $1.6m TBC and it is only any surplus that will need to be paid out as a lump sum.

When did you last review your SMSF trust deed?

Many trustees of superfunds don’t realise that when super legislation changes the trust may require updating. This is particularly critical when dealing with payments of death benefits.

While most trust deeds are written to provide the trustee with wide discretion, to be 100% certain, we strongly recommend they be reviewed. An updated deed will provide complete flexibility when it comes to dealing with excess transfer balance caps, the rollover of death benefits, reversionary and child pensions and effective binding death nominations.

Summary

Superannuation continues to be the most attractive vehicle to grow your wealth. It can also be a very tax effective estate planning tool. For a spouse and financial dependent, a lump sum benefit death benefit is tax free. For non-dependents (as defined by the ATO), there may be taxes of up to 30% on a lump sum super death benefit. Having said this, there are strategies you may be able to implement to significantly reduce, or even eliminate, this tax for non-dependents such as your adult children.

You must also be very careful when a reversionary beneficiary is dealing with a deceased’s pension when it will exceed their transfer balance cap.

If you would like to have a chat about it, we are more than happy to have a look at this for you.

Finding the investment strategy that’s right for you

Finding the investment strategy that’s right for you

by | May 23, 2018 | Financial Planning, Investments, Wealth Management

One of the biggest challenges any investor faces is working out the most suitable investment strategy. There’s no end of options to choose from and how do you know which one’s right for you? And once you’ve worked out a strategy how do you decide what specific investments to choose?

There are many, many books dedicated to these questions, so this post aims only to suggest some ways to start thinking about it. The key is, think about it you must!

When you’re trying to work out an appropriate investment strategy there are some basic questions to consider, the answers to which can be different for everybody:

  • What’s your time frame? Are you talking about a strategy to set you up for retirement, or to reach a specific goal (fund a house deposit), or is it open-ended (perhaps starting a nest egg for your kids)?

Put simply, the longer the time frame the more options you have to choose from. For example, if you’re 20 years old and want to start a long-term savings program, you can look at anything; on the other hand if you’re planning to retire in five years and work out you need to double your current savings in that time, well, your options are seriously limited.

  • How much are you going to invest? Are you starting from scratch or do you already have a lump sum? Again, you might be at uni and you’ve heard the best savings program is one that starts as early as possible, or perhaps you’ve just inherited a sizeable chunk of money and you’re presented with a challenge you’ve never had before.

If you’re starting from zero then presumably you’re going to be quite young; clearly the property market is out of the question, so you need to look at either shares or some kind of managed investment where you can drip feed money in.

Obviously the more you have to invest the more options you’ve got. Everything from property and shares to private equity and venture capital. Or a combination of things, that is, a diversified portfolio.

  • What is your appetite for risk? While this is possibly the most important question in investing, it can be a really difficult question to answer because everybody wants the joy of high returns without the stress of facing potential losses. Until you’ve lived through a market correction, where you’ve watched 20% of your money disappear in a hurry, you’re only able to guess what your risk tolerance is.

Conventional wisdom says if you’re young you should take on more risk, but what’s the point of that if you lie awake at night stressing about a potential share market fall? Likewise, if you’re embarking on an investment strategy relatively late in life that realistically may have to support you for 30-40 years, it would be unlikely that a super low risk strategy will see you meet your objectives.

At the end of the day you have to find a strategy you’re comfortable with and you’ll be able to stick to. Some people love property and just don’t really understand shares, others might freak out at the illiquidity of property. It ends up being a balancing act between where you want to get to (your risk requirement), being able to sleep at night (your risk tolerance) and your ability to recover from a correction (your risk capacity).

  • How much do you really know? One of the most influential biases identified by behavioural economics is that we tend to overestimate how clever we are. Believe me, there’s no point deciding you’re going to make your fortune trading futures if you don’t know a pork belly from a forex swap. And you may have heard you can make great money trading antique guitars, but if you don’t know how to pick a Fender Telecaster from a Gibson Les Paul with your eyes closed you’re going to get taken out backwards.

Work out if you’ve got an edge or if you have the time and inclination to learn one. If you’re a builder then naturally you may have developed a good feel for a property bargain. There are plenty of seriously wealthy self-taught investors, many of whom have taken the time to write books letting you in on their secrets, and if you’re not into reading, then check out YouTube.

Investing is like many things in life: if you have a plan and stick to it you’re likely to get much better results than making it up as you go. If you don’t really know where to start, then ask somebody whose understanding of how to make money you respect or admire. And if you don’t know someone who fits that bill, then find yourself a good adviser.

If you’re interested here are two books to get you started:

“The Intelligent Investor” by Benjamin Graham. This was first published in 1949 and is famous as being the most influential book for Warren Buffet and every on of his millions of acolytes.

“The Essays of Warren Buffett”, edited by Lawrence Cunningham, highlights some of the fireside chat wisdom from the man broadly acknowledged as the most accomplished investor ever.