Growing Wealth Through the Share-Market

The one thing that is severely under-communicated in respect of building wealth is the importance of starting young.

In fact, the three keys in my view are:

1. start young;
2. be consistent (I recommend 10% of after-tax income as a minimum); and
3. never touch the nest egg.

In order to demonstrate the power of starting young, investing consistently & leaving the investment untouched, I have created a ‘theoretical’ individual; let’s call him ‘Average Joe’. Average Joe is average in every way, most importantly for our examination, in earnings.

Average Joe Turned 20 on 1 January 1980. He immediately entered the workforce & immediately commenced earning the average wage (you may point out the unlikeliness of this – i.e. he would start earning less than the average wage and end his career earning a good measure more than the average wage). In any case, he immediately began setting aside 10% of his after tax income and has never touched his investment.

At present (for Calendar 2010), based on the Average Full-Time Adult Total Earnings from the Australian Bureau of Statistics, Average Joe earns $1,305.10 per week. He will earn $68,098.29 for the year and pay $13,979.49 in income tax (20.53%). I have used the mid-point from each year, you can check the ABS website for current and historic average wages - http://www.abs.gov.au/ausstats/abs@.nsf/mf/6302.0; it is pretty good for such information.

In his first full year of work (Calendar 1980), Joe earned $258.30 weekly, - $13,477.73 for the year. For simplicities sake, I have assumed he has always paid 20.53% of his gross wage in income tax (tax rates of course have changed frequently). So in calendar 1980, Joe saved $1071.08, with which he purchased an ASX200 index investment on the first trading day of 1981. Some said Joe was crazy, the ASX200 had advanced 48.86% in calendar 1980, and surely he was paying too much…

In calendar 2010, Joe will save $5,411.77, which he will invest on the first trading day of 2011.

Over the preceding 30 years, Joe has saved (and invested) $87,169.28. His current shareholding (bear in mind all he has ever done was buy the market with what he saved in the previous year on the first trading day – not at all strategic) is valued at $425,022.19.

In order to see how Joe might look come retirement age (which I will assume to be 67 by the time Joe retires in 16 years) we need to make some assumptions. I will assume Joe’s wages and the market move smoothly over the next 16 years at the same rate as they have done over the last 31, which I don’t think is unreasonable.

This being the case, when Joe retires on his 68^th birthday, on January 1, 2028, he will have earned $3,078,277.07 in his 47 year working life, or after tax have earned $2,446,306.78. He will have saved $244,630.68 (10% of his after tax income). The terminal value on retirement of his investment would be $3,789,336.58. That is fully 23.1% more than his gross earnings in his lifetime. Furthermore, it is 54.9% higher than his after-tax income.

These extrapolations are obviously just that, the average wage may not grow as quickly over the next 16 years as it has since 1980. The share-market may not achieve the same rate of return as the last 31 years. But Joe’s current results are impressive enough, and all he ever did was buy the market. It must be remembered that Joe’s investments are outside of whatever he has in superannuation as well. Average Joe will live well in retirement.

For those of you sceptical about projecting future returns, Average Joe’s Uncle, Average Joe Sr. commenced work at age 20 on January 1 1964 (earning the average 1964 wage of $51.70 per week), has earned the average wage all his life and will retire at age 67 on January 1 2011. He will have earned a total lifetime income before tax of - $1,261,141.11, after-tax income of $1,002,228.84. He will have saved $100,222.88, which he invested annually in arrears into the Australian Indices, without selecting specific stocks. As at today, 20 December 2010, Average Joe Sr. is worth $1,089,949.95, more than his total lifetime earnings. So you see my point (we don’t need ‘projections’ to make this look viable).

I appreciate there are many simplicities in this situation, for example, Average Joe Sr., would be earning something in the order of $40,000 in dividends annually, which would bring upon him additional tax obligations. This means, for example, instead of earning $68k in 2010, he would earn $108k. Instead of paying $14k tax, he would pay $27,910. When you factor in that his dividends historically in the ASX200 are franked at nearly 70% (about $12k in franking credits on $40k dividends), he is only out of pocket an extra $1,910. That’s a pretty small price to pay to retire a millionaire. The importance of starting young (point no.1) is demonstrated thusly – Average Joe Sr.’s first investment on January 1 1965 was $214.38, which as at right now is worth $40,540.23.

I will not post the next couple of weeks as I will be travelling (I anticipate January 17 being my next post), but I look forward to bringing you more of my ideas about wealth building in 2011, may it be a bright and prosperous one for us all - Tony Hansen 22/12/10

Investment Reading

Well, it’s nearly Christmas, buy someone you care about something useful, a book on investment, to help get them started on the road to financial security.
People, who are interested in investing, invariably will at some stage buy, or be given book/s about investing. I am no different than most, probably having consumed more financial literature than anyone I know. There are lots of really ordinary books out there, don’t let that stop you read everything you can lay your hands on.
I highly recommend this (scatter-gun) approach. It is my opinion, barring a couple of really ordinary books that, virtually every book on finance or shares or stocks or investing or property or trading or options or derivatives I have read added to or improved my understanding of finance and investing in some way.
What is entirely undeniable is that some books will do substantially more to enhance your knowledge than others.
Depending on your level of interest and/or experience in investing will depend on where you should look first. If you are fairly new to investing in shares, or simply aren’t inclined to read hundreds of books to have a completely rounded knowledge of the subject, the first book you should read is Motivated Money by Peter Thornhill. Thornhill presents an outstanding analysis of the importance of using shares as a principal theme in building the wealth and income stream needed to retire self-funded. I have never met Peter, but I guarantee that even if you have an extensive understanding of markets, you will benefit from this book. I was lucky to stumble across this book; in fact it was my business partner, Dave who found a copy in a second-hand bookstore. Irrespective, you can order the book from the website: https://www.motivatedmoney.com.au/ and it is well worth paying full retail. As an aside, Peter Thornhill uses his website to periodically make comment on the state of the markets, or whatever is on his mind and the information is well worth reading also.
For the investor with more experience and who is inclined to spend more time developing a fuller knowledge of how to properly value individual companies. The best book for such a person would be ‘The Intelligent Investor’ by Benjamin Graham. Graham is considered the ‘Father of value investing’ and deservedly so, this book is in my view central to building a complete framework within which to analyse shares.
Finally, for the really passionate investor, in my view, you can’t be considered to have completed your education in the markets (you never really 'complete' your education) until you have waded through ‘Security Analysis’ by Benjamin Graham & David L. Dodd. It is a pretty epic read and not as user-friendly as the other two books mentioned here, but it is really a solid capstone for an investor who wants to knowledgably analyse potential investments in a truly businesslike manner. If you are going to take the time to read investment books, then start with the best. These are the best place to start - Tony Hansen 15/12/10.

Borrowing to Invest

Borrowing to invest is often demonised in the financial press. It is referred to as ‘leverage’ and for good reason, it ‘levers’ up your gains and losses. The only time the leverage has no apparent effect is when the return is the same as the cost of the leveraged capital. Recent examples to demonstrate the potential effects of leverage (I will use the rate from a Line-of-Credit I have operated over the periods in question, you may have been able to borrow at higher or lower rates yourself):

1. On 30 November 2007, you decided to borrow $100,000, in order to purchase an investment in the S&P ASX200 (TR) indices. In the ensuing 3 years to 30 November 2010, the annualised return has been -7.01% pa, which means your original capital is now worth $80,409.76. During this period, at your average of 6.8648% borrowing costs, you also paid $20,594.40 in interest costs. When you subtract your borrowing costs from your remaining capital, you are left with $59,815.36, which implies an annualised return of -15.74%. Your negative result has been amplified considerably more than the -13.8748% loss indicated by the difference sum of the borrowing costs and the negative growth.
2. Fortunately, 10 years ago, on November 30 2000, you decided to do the same thing. Your annualised return has been 7.8% pa, which means your original capital is now worth $212,012.31. During this period, at your average of 6.6302% borrowing costs, you also paid $66,302 in interest costs. When you subtract your borrowing costs from your remaining capital, you are left with $145,710.31, which implies an annualised return of 3.84%. Your positive result has been amplified substantially, instead of capturing the 1.1698% (difference between interest costs and earnings rate).

Both of these periods, we must bear in mind cover the worst market period in living memory (unless you’re really, really old…). The other thing that is left out of the calculation is the ‘negative gearing’. In simple terms, in relation to the examples above, assuming you were in the 38% tax bracket, this effectively means that the government effectively covers 38% of your borrowing costs by virtue of tax you will not pay due to your annual income being reduced by the interest charges produced by the borrowed sum.

In the case of the second example above, when we strip out the $25,194.76 of borrowing costs the government effectively pays; you are left with $170,905.07 after paying ‘your share’ of the interest. Your new annualised return is 5.51% pa, which is about 4.7x the 1.1698% difference between the borrowing costs and the investment return.

There are two key mistakes people make when borrowing to invest. The first is the wrong type of borrowing. Margin lending, for example, is fraught with risk, if your holding declines below a certain point, your shares can start to be sold out from under you. Shares are volatile, as Warren Buffett says ‘Unless you can watch your stock holding decline by 50% without becoming panic-stricken, you should not be in the stock market.’ If you use margin lending, the choice may not be yours. Unless you can borrow against an asset, and are confident that even in the event of a downturn, you will be able to service the debt, then ‘leverage’ is not for you.

The second mistake people make is timing. If I met someone with $500,000 of available equity to borrow against, say in their home, I would strongly advise against borrowing the whole sum right now and investing it all. This is despite my opinion that the market over the next 5 years is likely to perform equal to or better that historic averages. More prudent in my opinion would be to set up a strategy, whereby each month over a 4-year period, about $10,000 was invested monthly, this will enable the investee to ‘dollar-cost average’ their purchase and ensure they build their holding at a price that will evenly reflect the market average price over the period.

Borrowing to invest is a reasonable strategy, provided you are cautious and bear in mind these types of issues, and remember, the higher your tax rate, the more viable the strategy is. A taxpayer in the 45% tax bracket, who can borrow at 10% pa over a period, needs only be confident that their investment will grow by more than 5.5% per annum to justify the investment. Compare this to an individual in the 15% tax bracket, who would need to be assured of at least an 8.5% return to end in positive territory. Tony Hansen 08/12/10

Taxation Value of Equity Investments, Part 2

To clearly demonstrate the advantage of buy and hold equities, I will posit the following situation. Ten years ago on November 23, in the year 2000 you had $10,000, which you wanted to invest in a quality Australian company. I was originally going to say you chose BHP (whose performance I might add was much better than the stock I chose), however, they have done several things like stock splits & de-mergers in the last 10 years, that make a retrospective calculation tricky.

I should comment that hindsight stock picking is easy, the selected stock is not relevant, it is the decision point we come to 10 years later that I seek to demonstrate.

So I settled on Woolworth’s (WOW), a nice stable company with a solid history & good prospects. You took your $10k and purchased 1298 shares ‘at market’ and got them for $7.70 ($9,994.60), I have left off brokerage, as I don’t think it relevant to the discussion. In any case, you signed up to the WOW DRP (dividend reinvestment plan), put the stock in the drawer and forgot about it.

Today, November 22, in the year 2010, you examine your WOW holdings and find that you own 1810 shares, worth $48,779.50 at today’s closing price of $26.95. This comprises:

1. Starting capital = $9,994.60
2. Re-invested dividends = $10,663.54 (512 shares @ average of $20.83) &
3. Capital gains = $28,151.36

Genius investment you say, well you could have sold the whole parcel for about $10k more in late 2007. By the way, the part of the investment you don’t see is the over $4k in franking credits you also received (an important factor I think is under-recognised by most investors).

In any case, the decision point is this. You believe that WOW are likely to perform at best marginally better than the market, however, you have discovered another share, XYZ – that you believe can outperform the market over the next 5 years by 3% per annum.

Should you sell now and invest? We’ll make these assumptions 3:

1. The market performs at its historic average over the last 30 years, by performing at 12.47% pa for the next 5 years
2. You are also correct about WOW performing only marginally better than the market, they maintain their historic 3.22% dividend return, with a 10% annual capital gain for a 13.22% total return (only 0.75% better than the market)
3. You are also correct about XYZ, over the next 5 years, they return a total of 15.47% pa including reinvested dividends (3% over market returns)

So what do we see on November 23, in the year 2015?

1. If you stayed in WOW, and returned 13.22% pa, our investment would be worth $90,751.35
2. If you sold your WOW & crystallised your $28,151.36, using the 50% capital gains tax discount, you paid tax of $5,348.76 (assuming a 38% tax rate) on your taxable gains of $14,075.68. You invested the after tax amount of $43,430.74 in XYZ and it was worth $89,154.46 after 5 years.

Well, despite our investment in XYZ annually returning 2.25% more (not an unimpressive effort) than WOW over the 5 years, our investment was still worth $1,596.89 less than if we did nothing. In fact, over a 5-year period, under the figures used, XYZ would have had to generate 15.88% (2.66% pa better than WOW) just to equal the performance of WOW over 5 years.
The lesson? Don’t change investments on a whim, because it seems clever. Unless you are virtually certain that an alternative investment is substantially better than your current one, there is a high likelihood that you are better to leave the ‘free leverage’ provided by your ‘unpaid tax’ on current investments. Tony Hansen 01/12/10.