Financial planning's big six
October 20, 2008
PORTFOLIO POINT: From regular investing to paying off debt, there are six basic elements of a financial planning strategy all investors should consider.
The long slow fall of the sharemarket raises many questions for investors, and challenges some of the "faux wisdom" that had crept into the market. For example, over the past three years I had many people tell me that the "weight of money" coming into the market on a regular basis from compulsory superannuation would prevent a repeat of the 1987 sharemarket crash.
Others said that the mass of online data in this "information age" would reduce the volatility of shares because investors would be better informed and make more rational decisions. It seems the most recent sharemarket downturn has proven both these theories wrong.
Given the dramatic return of the "reality of volatility" in sharemarket investing over the past 12 months, it is worth remembering that a successful personal finance strategy has two parts: the underlying investments and the strategy that will help manage tax, build wealth and, over time, move you towards a position where you can retire.
It is important to evaluate these personal financial strategies in light of the current market volatility. I want to look at six key strategies.
Investing regularly over time (dollar cost averaging)
This is the strategy of regularly investing into assets.
At first glance this seems to lack the sophistication of other financial planning strategies. However, many people talk about the "miracle of compound interest" where, over time the investment earnings on investment earnings create a snowball effect of fast-growing wealth. Regularly investing over time creates a compounding effect for the miracle of compound interest, where the investments are not only exposed to compound interest, but also to additional investment contributions.
Investing regularly over time is also the opposite of trying to time markets. which is hard (perhaps impossible) to do at the best of times, and even harder during a period extraordinary ups and downs.
There is a Peanuts cartoon that I remember in which Charlie Brown says that the secret of happiness is to own a convertible and a lake. That way, if the sun is shining you can say that it is a great day to drive the convertible; if it is raining you can say that it is great because the lake is filling up. Dollar cost averaging is like this: if markets are up you can say that this is great because your portfolio is going well. And when markets are down (as they are now) you can say great, because you are buying more assets at low prices.
It is a great strategy in a period such as now; investing regularly takes the pressure out of having to call the bottom of the market cycle, while regularly buying assets at much lower prices than they were available 12 months ago.
Keep in mind that this is how most of us contribute to our superannuation: adding regular investments as markets move up and down.
Repaying non-tax-deductible debt
Repaying your non-tax-deductible debt (mortgage, credit cards and personal loans) might hardly seem part of a sophisticated financial planning strategy to the average Eureka Report subscriber.
Consider this: every additional mortgage/credit card repayment provides you with a tax-free investment return equal to the interest rate on that debt. That might be a 16% tax-free return on a credit card or an 8.25% return on a mortgage.
Repaying debt also reduces the amount of borrowing in a person's overall situation, a reduction of your overall exposure to interest rate movements and a reduction in the amount of your income required to service debt.
This is a strong strategy in times of uncertainty like these; the returns from repaying debt more quickly are risk free.
Borrowing to invest
Borrowing to invest - gearing - is a staple personal finance strategy. The strategy sees someone take on more investment risk, to increase the expected return of their portfolio.
Earlier in this market downturn it was discussed in two articles, Margin loan? Think again and Is share gearing worth it?
I don't have a lot to add to these articles, which outlined the volatility and risks of a gearing strategy, except to say that I am in the process of reading the The Snowball: Warren Buffett and the Business of Life. He always stated a reluctance to borrow to invest. However, when he was young and wanted to increase his $20,000 portfolio he only borrowed a further $5000. In today's terminology this would be a "loan to value" ratio of 20%. So, when the world's greatest investor did put some borrowed money to work it was with a loan to value ratio of 20% - a cautionary tale for all of us who are realistic enough to know that we are not Warren Buffett.
The important aspect to such a strategy is that the current volatility increases the chances of seeing a sharp drop in portfolio values. Anyone using a gearing strategy should have contingency plans in place if their portfolio value drops sharply. Borrowing to invest often takes up a lot of investment cash flow. This makes it tougher to be buying extra investments and taking advantage of a situation when values have fallen as they have now.
Salary sacrificing to superannuation
Salary sacrificing to superannuation is the strategy whereby pre-tax income, which would usually be taxed at 31.5% for the average income earner, is diverted into superannuation where it is only taxed at 15%.
The core of this strategy is the tax saving. For every $10,000 salary sacrificed to superannuation the tax saving is $1650 a year. It might not sound much, but it is a little over $30 a week, or close to $1 for each hour worked. And no one would refuse a $1 an hour pay rise.
This remains a great strategy in the current environment; any tax saving has to be a positive. People approaching retirement might consider a subtle change, to increase the extent to which future salary sacrifice contributions are invested in cash. That way, they can build up enough cash to fund their first three to five years of retirement and can avoid having to sell growth assets if the market volatility continues.
The downside of salary sacrificing to superannuation is for younger people who can't access contributions until age 60. Given comments about a more difficult economic environment in the short term, if they feel that they need any extra cash (for example, if they run a business and think profits might drop) they may be wise to reduce the salary sacrifice contributions and build up some cash outside of superannuation. Other than that, it should be "all systems go" with a strategy that saves tax and sees a person regularly investing over time.
Transition to retirement strategy
This strategy involves drawing on some superannuation benefits in a tax advantaged way, while salary sacrificing additional income to superannuation.
There are articles on this strategy (see Get onto this rort), and my opinion is that for people over the age of 60 and still working this is the most powerful financial planning strategy that there is.
In the current environment a powerful strategy such as this works well. Similar to the comments on the salary sacrificing strategy, people getting close to retirement might consider increasing their salary sacrifice contributions to cash if they need to build up their cash balance close to retirement.
Income planning in retirement
Retirement becomes a key time to think about the asset allocation of a portfolio. A key strategy is to look at a portfolio from the perspective of how much income has to be paid out of the portfolio, and plan for that. For example, consider a $1 million portfolio where a person wishes to draw at the rate of $50,000 a year. Having (at least) $250,000 set aside in cash means that the person knows where five years of income are drawn from. That $250,000 is topped up by the interest, dividends and distributions from the remainder of the portfolio; if the portfolio is providing an average gross yield of 6.5% then this is $65,000 a year. The result: a person should be able to draw an income from the portfolio of $50,000 a year, increasing with inflation, by relying on the initial cash allocation and the stream of interest, dividends and distributions to the cash account.
This is a strong strategy in a volatile market; suddenly the inevitable volatility of growth assets such as shares and property are less important because of the cash that you have available and the income earned by the portfolio, both of which are far more reliable than having to rely on the ups and downs of the market.
Difficult investment times make it more important the underlying personal finance strategy is working for you. Settling on a strategy, and understanding why it works, will help in working through this current difficult market.