In our last post, Kim from Sydney left me a question:
..... could you please elaborate on where the personal post tax investments were placed to earn such a large amount? The best I can find in term investments is not much more than 2.5% - less than inflation. thanks.. Kim from Sydney :)
I thought this question was worth doing a post on - so here goes.
There are several parts to this astute question from Kim that I need to quickly dissect then answer. Kim has rightly identified that:
1. Banks rarely currently pay much more than 2.5% interest
2. Kim is referring to investments OUTSIDE of super - implied in this is the negative affect of tax on investment earnings and capital gains tax
3. Where investment should be placed to get such large earnings
4. That there ARE large earnings
If you look at the last post and reverse engineer the maths you will see that the rate of return that I have used is 7%. You may say that this is impossible seeing as banks rarely pay more than 2.5% interest on savings and that this also seems to be dropping - this is certainly correct. Money in the bank is not a true investment for this very reason. Once banks start paying 5% interest or above will be when cash in the bank will be once again considered a low level investment. So, where does the 7% come from?
The 7 % comes from investing in the share market - both Australian shares and international shares. This may make you stop reading straight away, but please hang in there. Every Australian's superannuations are invested in shares in various ways, thus most Australians are invested in the share market without even knowing it, the difference is that their Super fund is managing it and often for a sneakily delicious fee.
However, shares certainly scare people. Everyone can quote the big share market crashes with people loosing fortunes etc, etc and this (along with zero knowledge of even the simplest workings of shares) is why people give shares a miss. Some people dabble in shares and due to lack of basic good advice end up just gambling and losing money. Thus many folks favour property. Property investing can certainly return good results, but for the average investor, once stamp duty is paid, inflation factored out, landlord insurance is paid, maintenance on the property is paid, interest on the investment mortgage is paid, land tax paid, real estate management fees paid, accountant's fees paid, repairs and damage paid for and vacancy is absorbed there is little real profit to speak of and many people end up selling their investment property because it simply is not real money in the bank. Besides that, it is so hard to save up the huge deposit required to enter into property, the growth in the house value cannot be accessed easily without selling the whole property (you can't knock a brick out and go and swap it for a loaf of bread!) and the obvious fact that there is zero diversification when all our money is in property makes it a problematic investment - often you'll go backwards for many years unless you are very canny.
So back to shares - here are some facts:
- The share market as a whole (not individual shares) conservatively over long periods returns 7% on average. (Some years it returns 20% and some years it is in the negative)
- Shares can be bought into with as little as $500
- Shares can be purchased regularly
- Shares can be bundled together to create excellent diversification via purchasing ETF's (Exchange Traded Funds)
- Shares can pay income - this income is know as dividends (yield)
- Shares can increase in value - this is call growth or capital gains
- Shares can both grow and yield
- Shares are very easy to buy and hold
- Tax time is NOT difficult when you hold shares
- Many Australian share dividends have 30% tax paid on them already (100% franked dividends)
- Fully franked shares (30% tax paid) is a wonderful tax saving strategy
- International shares often have much higher growth than Australian shares - (Australian shares are less than 4% of the world's entire share market)
- Share growth (Capital Gains) is only taxed if the share is sold and the CGT (Capital Gains Tax) is halved if the share is held personally for 12 months or more.
- A buy-and-hold-forever share strategy will rarely if ever attract CGT
- Shares dividends can often be automatically reinvested if you enter into a DRP (dividend reinvestment plan) with the company or share provider - this is automatic compounding
- When the share market 'crashes', wise investors will buy up big on quality shares. Shares are at their cheapest in a 'crash' (or correction)
- The share market 'crashes' (corrects) often. It is normal and expected and nothing to be feared. It is when you buy up shares because they are on special! Uneducated people panic and sell.
- Quality dividend yielding shares will continue to pay dividends right through down turns and corrections - quality dividend paying shares are truly 'all weather' stocks
- Shares can easily be divided up for estate planning purposes
- LIC's (Licensed Investment Companies) are worth considering as they buy up big bundles of quality shares over many decades - thus owning one of their shares gives you part ownership of many businesses. Quality LIC's pay fully franked dividends and also realise share growth too ..... the best of both worlds
- ETF's simply mimic the market. ETF also are bundles of many different shares (bundled according to the ETF sector, theme or purpose) and by buying one ETF you are part owner in many businesses. Quality ETF's also pay dividends and realise growth (yield and growth)
- Conglomerates are similar to LIC's in that they own shares in many business. Often conglomerates will own very large percentages of quality businesses and pay excellent fully franked dividends
With shares it is important to look at a minimum 7-10 year investment period or longer. Conservatively, I choose to use 7% return (a combination of growth and yield) even though in many years the return is much greater than this. Erring on the side of conservative is far more prudent, especially when making long term calculations like in my previous post.
The other vitally important factor when investing is time. The 8th wonder of the world most certainly is compound interest across time and when using the conservative 7% approach this means that every ten years you can pretty much double your money.
Time in the share market means a long term commitment to buy and hold - not to sell. By buying and holding the following can occur:
- Share dividends can be reinvested and snowball over time
- Share growth can accumulate over time
- DRP means more shares are bought automatically without any emotional decision-making required
- Dollar Cost Averaging (DCA) will occur if you are regularly investing meaning that some share parcels you will buy when the price is high and some you will buy when the price is low, thus over time a pure average cost is paid for your shares.
- Time allows a few stock market 'crashes' to occur which give wonderful opportunity to buy up quality shares very cheaply
- Time in the market means that you will always see the share market bounce back - and it always does bounce back
- People who panic when share prices drop never benefit from share bounce-back nor the opportunity to buy quality shares cheaply - in fact, they stupidly make a loss by selling up instead of simply allowing time to pass and sticking with it. (You would not sell a house when the housing market crashed - then why do it with shares for goodness sake??!!)
- Ensuring you buy good quality dividend paying shares will mean that earnings from dividends occur even in market downturns and when these dividends are reinvested they are buying extra shares at their cheapest. When the share market bounces back, these reinvested dividends bought during a downturn increase their intrinsic value dramatically.
Investing wisely is even more important outside of superannuation than it is inside superannuation. So the following is important to ensure your investments outside of super and bought with post-tax dollars are the best they can be. The following will ensure the best bang for your buck outside of super.
- Investments outside of superannuation allows you to retire or semi-retire well before preservation age. This is because you can access these investments at any time as there are no access restriction like with Superannuation. The younger you are the truer this is.
- As these investments will be taxed ON TOP of your current earnings it is important that the shares purchased are the wisest for taxation considerations. Shares that hold or increase their growth but also pay good dividends are the best. Not only that, dividends that are fully franked (already have 30% tax paid on them) will potentially save you significant amounts of tax. Depending on your top tax bracket you may either get a tax refund or only have to pay the difference between the 30% already paid by the share company and your tax bracket. Once you are eventually living off these investments the 30% tax may even cover most of your tax responsibilities depending on your circumstances.
So very simply, investing wisely in shares that pay good regular fully franked dividends is essential. Also, making sure that your investment strategy is buy-and-hold is essential to create long term wealth, avoiding unnecessary CGT, taking advantage of buying up when the stock market 'corrects' and committing to reinvesting every penny earned until you are ready to retire or semi-retire is key. Understanding that the stock market as a whole, will, on average, over the long term return 7% as a combination of growth and yield. Never being tempted to use higher rates when doing your calculations otherwise disappointment will be certain.
At their current interest rates, banks are nowhere near being adequate investments compared to the stock market, nor are bank interest rates fully franked or have any such tax benefits. When bank interest rates settle at 5% I will begin to be a little interested and if they increase to 10% then I will certainly apportion some money to them ..... but usually if banks are paying 10% interest (or above) then the economy is usually running at wild inflation rates which is another set of worries entirely!
In my personal unqualified opinion only (and despite the scaremongering) shares are potentially the wisest long term investment with the best tax advantages for normal folk who have no special market skills elsewhere. For the record, I hold shares in AFIC, Argo, Milton, Washington H Soul Pattinson, Vanguard VGS and Vanguard VGAD - click on each for links to info on each. As you can see I go for 'wise old owl' companies that share the same thoughts and goals as this post. I will not get rich quick, but I will get rich quietly and certainly. I now need to ensure my future monetary wealth is matched with equal amounts of wisdom, personal integrity, humility and generousity.
Kim, I hope this post gave you and indeed all our readers here at Mr Home Maker the detail needed ..... or at least a kindly 'shove' in the right direction. I'm not a qualified financial adviser so please do your own research.
Take care folks and stay nice.
Mr HM (Phil)