One thing that does not get nearly enough coverage when talking in terms of wealth creation is the important taxation differences between the various asset classes. People talk about the ‘safety’ of having your funds in cash. When it comes to people like self-funded retirees, with just enough asset coverage to see them out, cash is a valid investment position. For someone with a long-term investment horizon, say younger than 55, or older, but with substantial assets, say more than $2m, cash will likely be a significant anchor on your performance.
The reasons are many. The historically superior performance of shares versus cash is simply the one that gets the most attention. Capital gains legislation in Australia provides most of the other advantages. The immediate taxation of income versus the deferred taxation of gains (as with most other countries), but most especially, the 50% discount for capital gains held over 12 months. I can’t stress that advantage enough, particularly for long-term holding as the ‘untaxed’ gains in your portfolio compound, effectively using your future taxation obligations as ‘free-leverage’.
Example - assume you are in the 38c tax bracket (between $80k & $180k in earnings). If I told you that over the next 10 years, the average interest rates on term deposits available would be 10% and the average growth in equities over the same period would be 10% (6% growth & 4% in dividends). What would you do with the $10,000 you wish to invest? For most people, the steady increase of the term deposit would be attractive, because despite both seeming to get to the same end result, the equities would probably be more lumpy, perhaps (4% / 16% / -10% / 23% / 17%) and so on. Assuming they were smooth, the end result would look like this:
The reasons are many. The historically superior performance of shares versus cash is simply the one that gets the most attention. Capital gains legislation in Australia provides most of the other advantages. The immediate taxation of income versus the deferred taxation of gains (as with most other countries), but most especially, the 50% discount for capital gains held over 12 months. I can’t stress that advantage enough, particularly for long-term holding as the ‘untaxed’ gains in your portfolio compound, effectively using your future taxation obligations as ‘free-leverage’.
Example - assume you are in the 38c tax bracket (between $80k & $180k in earnings). If I told you that over the next 10 years, the average interest rates on term deposits available would be 10% and the average growth in equities over the same period would be 10% (6% growth & 4% in dividends). What would you do with the $10,000 you wish to invest? For most people, the steady increase of the term deposit would be attractive, because despite both seeming to get to the same end result, the equities would probably be more lumpy, perhaps (4% / 16% / -10% / 23% / 17%) and so on. Assuming they were smooth, the end result would look like this:
The difference you will agree is quite substantial, the cash/term deposit option (with the assumed 38c tax rate) naturally returns net – 6.2% per annum. The equities netted an annualised return of 7.865% despite what is ostensibly the same return. Obviously property can have similar capital growth benefits. Held for long enough (over 40 years or so), the dividend would eventually be a larger per annum payment than the 10% cash return, at that point your capital base (the funds column) would be over 2 & 1/3 times larger in the equities column than the cash.
There are of course other factors to consider, like capital gains & franking credits and so on. But the basic fact remains that an equity investment assumed over the long term to grow at the same rate as the equivalent cash investment will actually be considerably more valuable.
So, given that if the returns were expected to be exactly the same, equities would prove to be a substantially more lucrative investment, it is probably a more worthwhile comparison if we us their historic returns. For the 30 years from January 1 1980 to December 31 2009, the average cash rate was 7.24% (we’ll call it 7.25%) and the average return for the S&P/ASX200 (TR) was 12.47% (we’ll call it 12.5%) with approximately 4% of the growth in dividends, would look more like this:
There are of course other factors to consider, like capital gains & franking credits and so on. But the basic fact remains that an equity investment assumed over the long term to grow at the same rate as the equivalent cash investment will actually be considerably more valuable.
So, given that if the returns were expected to be exactly the same, equities would prove to be a substantially more lucrative investment, it is probably a more worthwhile comparison if we us their historic returns. For the 30 years from January 1 1980 to December 31 2009, the average cash rate was 7.24% (we’ll call it 7.25%) and the average return for the S&P/ASX200 (TR) was 12.47% (we’ll call it 12.5%) with approximately 4% of the growth in dividends, would look more like this:
I know I am not alone in making this prediction. There is a better than average prospect, given the spikes in commodity prices and the economic policies being undertaken by the two largest economies in the world that we could be in for substantial inflation over the next 10 or 15 years. There is no better protection for your net worth during such a time than having a substantial proportion of your net worth invested in a group of stocks with good pricing power. Tony Hansen – 24/11/10
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