How and Where to Invest Your Savings Now

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Are there any perfectionists among readers of this blog?  Perfectionism is a useful trait in medicine.  But it can cause indefinite procrastination when deciding how to invest.

If you want to improve your financial situation, you need a plan.  No plan will be perfect, but it will give you a direction to start.   Goals can be changed and plans altered.

There are three main ways to make a plan:

1. FIND A TRUSTED ADVISER

You will need to research a trustworthy adviser.  A retirement age, income and other goals need to to be decided.

2. MAKE YOUR OWN PLAN

Again, you will start with setting goals, then work out a strategy of how to achieve those goals

3. START INVESTING NOW

and work it out later

Investing without a plan risks needing to change course later.   You will pay capital gains tax if you sell to move investments.

But if you have no idea about goals, making a 40-year plan can feel overwhelming.  It’s better to get started than procrastinate indefinitely.

Investing small amounts regularly over a long time accumulates wealth.  The power of compound interest is incredible.  Investing $100 weekly from age 20 results in $1.146 million dollars by age 60 (assuming 7% Growth)!

Money Smart has a simple savings calculator for calculating savings goals.  An arbitrary goal to save, for example, an additional million dollars in superannuation is better than none.  You can perfect the plan later when your goals become clearer.

How and Where to Invest: Set a Goal, Time Frame and Strategy

With your goal(s), calculate how much you need to accumulate within what timeframe.  Next, it’s time to consider broad strategy, before getting into individual investments:

  1. Invest inside or outside superannuation
  2. Invest for capital gains or income
  3. Taxation considerations
  4. Choice of Assets & Asset allocation

How and where to invest your savings: Inside or Outside Superannuation

– Inside Superannuation

Employees are compelled to save for retirement by super.  Superannuation builds wealth through compound interest over your long career.

Super locks savings away until preservation age (currently 60yo).  This illiquidity is generally considered a disadvantage.  However, it protects investments from impulsive withdrawals.  Failure to stay the course is the biggest risk for most!

Many employers allow salary sacrificing into superannuation.  Others (such as self-employed individuals) can tax deduct their superannuation, with the same results.

Contributions into superannuation are taxed at only 15% assuming gross earnings <$250,000.  This is far lower than most people’s “Marginal tax rate,” saving lots of tax.

A worker earning $70K salary sacrificing $115 into super will only be ~$78/week out of pocket.

The graph has not taken into account dividend taxation, which will worsen the higher tax situation.  Your superannuation can be converted to a tax-free income stream after retirement.

If you (and your partner) earn more than $18,200 annually, investing a little extra into your superannuation is a no-brainer up until you earn ~$250,000.

– Investing Outside Superannuation

There are a couple of situations in which you are better off investing outside super.

  1. If you intend to retire before the preservation age (whatever it will be at the time). The preservation age is the age you can withdraw super tax-free (currently 60).  Those that want to retire earlier should invest some outside super to bridge the gap.
  1. You (or partner) will earn less than $18,200 annually long-term. In this case, the non (or minimally) earning spouse can invest in tax-free growth.  You could expect to invest around $300,000 before paying tax on dividends.
  1. If wanting to purchase property as an investment. Self-managed super fund borrowings usually result in less leverage, higher interest rates, large fees, and lots of hassle.  High-income earners benefit from tax benefits of growth (negatively geared) properties. Positively geared property income can be tax-free if earning less than $18200.

After retirement, most will aim for around $18200 or less income per person outside of superannuation in order to minimize taxation.

How and where to invest your savings: Capital Growth or Income Assets

– Investing for Capital Growth

Capital growth investing relies on an increase in value of an asset over time.  Income produced initially is not a priority, in fact the investment can cost money each year.

Growth investors expect investments to produce a good income stream over the long term.  This income can result from increasing yield over time, or sale of assets.

A high earning professional may choose to buy an investment property with good capital growth potential.  Capital growth and yield (net rent) tend to be inversely correlated.

Rent received on a capital growth property will be inadequate to cover mortgage interest and other costs.  So, the investment will produce a negative yield overall.  High earners tolerate this because they focus on creating an income stream during retirement.

Tax refunds compensate partly for the lost income,  This is a tax-efficient investment, as long as the capital growth eventually occurs.

The capital growth strategy can also be used when investing in the stock market.  Warren Buffet’s investment company Berkshire Hathaway famously pays no dividend.  Companies have a choice when they produce a profit.  To use that income to invest back into the business, or pay a dividend to investors.

A capital growth strategy can sometimes result in a cash flow deficit despite large asset value – especially with property portfolios.

– Investing for Income

It seems intuitive to invest for income.  Income investors have their eyes on the prize.  Income starts minuscule, but over time grows.   These investors don’t want to rely on capital growth that isn’t guaranteed.

Income investing will produce some income faster, which gives investors more cash flow security.

Income vs Capital Growth Income Comparison

Below is a graph that demonstrates gross income (yield) produced by two properties that deliver consistent 11% total returns annually.

A yellow line represents a “Yield” property – with returns consisting of 7% yield, 4% capital growth.

An orange line represents a “growth” property returning 4% yield and 7% capital growth.

The yield property produces more income until around year 21, when the capital growth property overtakes.  Both are assumed to be completely un-taxed throughout.

Income investing usually has a lower barrier to entry.  It is often more suited to lower-income earners.  Property, shares, bonds and fixed interest can be counted as income investing.

High yield property tends to be cheaper, in more regional areas.  Some can be extremely volatile, particularly in one-industry towns.

Everyone was into mining town properties a few years back, encouraged by high returns from extortionate rents.  With the downturn in mining, these properties often lost half their value and the tenant pool dried up.

A carefully selected income property with carefully screened tenants can produce an income stream that increases with inflation.

Shares brought for income fall into the “Dividend investing” category.  Certain companies are expected to pay consistent dividends, others focus on capital growth.

The idea with share income investing is that dividends gradually increase over the years.

Bonds are often included in retiree’s portfolios, due to lower volatility and predictable income.  They are expected to provide a lower return long-term than shares, but more than cash.  Many investors like to transition more into bonds as they age, and capital protection becomes a higher priority than growth.

– Capital Growth vs Income Investing: Timing

Capital growth has the potential to create greater income eventually but needs a longer time frame. Without enough time, investors can end up “Asset rich, Cash poor”.

Many investors will benefit from using both strategies, capital growth initially to build a large asset base, before pivoting towards income investing in later years.

The capital growth experienced initially can be used to leverage into higher value income investments and grow income faster than a pure investing for income strategy.

I found the book “Investopoly” by Stuart Wemyss* did a good job of explaining a broad strategy to combine growth and income investing efficiently.

How and Where to Invest Your Savings: Taxation Considerations

Take some time to consider your tax position.  Are you (+/- partner) high-income earners, expecting to pay increasing tax over the coming years?  Is an adult in the household planning to give up work or earn minimally for several years?

Investments should not be made for tax reasons.  Decide on a broad strategy and investments first, then work out how to minimize tax.

Many investors have lost money through investments designed to reduce tax.  It is also illegal to avoid tax or make investment decisions based on taxation.

Dividends are taxed at your marginal rate.  Capital growth is tax-free until sold – and discounted by 50% if owned for at least a year.

Therefore, a tax-paying investor may benefit from minimizing dividends paid in order to compound capital growth tax-free until retirement.

Tax paid at 30% within the company on profits reinvested is more tax-efficient than high-income earners being paid dividends.

Franking Credits

“Franking credits” mean that investors avoiding paying tax twice.  Tax is paid on profit within the company before the dividend is paid.

A tax (imputation) credit is applied to the dividend so the investor only pays their marginal rate on that dividend.  This means a refund for those paying less than 30% tax, but still produces a tax bill (marginal rate – 30%) for higher-income earners.

Franking credits improve returns for those with a marginal rate of less than 30%.

For higher-income earners, Australian Financial Investment Company and Whitefield allow “Dividend substitution” plans – where extra shares are awarded instead of dividends paid, resulting in no tax paid during the accumulation period.

how and where to invest

How and Where to Invest Your Savings: Asset Allocation

There are 4 main asset classes – property (residential and commercial), shares, fixed interest (bonds), and cash.  As I said earlier, there is really no ideal asset allocation, but your age and risk tolerance should be carefully considered.  There are several Asset allocation calculators online – including at Bankrate and Smart Asset.

I haven’t found one that includes direct property investments.  It’s easier to consider how much property you wish to own at retirement initially, and then work out asset allocations for the rest.

This may be more aggressive for initial years and transition to a lower volatility portfolio as you near retirement.  It is important to have a written plan of how you plan to invest so that you re-balance your portfolio when your allocations get out of balance.

– Cash

Cash loses purchasing power over time, due to inflation.

This is the least efficient way to accumulate wealth (ignoring debt!).  Cash should be kept in an account to cover 3-6 months of essential expenses in case of an emergency.  Self-employed persons or those who feel their income is not secure will want to save 6-12 months.

Any more than this is an opportunity cost.  The cash component puts me off pre-mixed diversified portfolios such as VDCO.  Cash, for me at least, needs to be separate from the rest of my investments in my bank/offset and available immediately when required.

A bank account will probably pay less than 2% interest, so offsetting this cash against your home mortgage is the ideal way to maximize your return tax-free.

– Fixed interest

Term deposits (AKA Certificate of deposit) lock up your cash for a defined period of time and return a set interest rate (currently extremely low).  I would consider buying a term deposit for if interest rates became incredibly high, but can’t see any benefit at current rates.

Bonds

Bonds can be brought directly via the ASX, in a bond ETF such as Vanguard VGB or Ishare IAF.  You likely own some in your superannuation.  They have traditionally lower growth and volatility than shares, but higher interest than cash investments.  They are intended to provide a more stable income source and to reduce risk and volatility.

Investing in bonds means loaning your money for a fixed period and receiving fixed or “floating” (variable) interest (AKA coupons).

They vary in risk from government bonds (rated AAA) to higher risk bonds for companies or countries that are less creditworthy (rated down to D).  Asset allocation to bonds traditionally increased with age, to lower the volatility of your portfolio.

Prices can fluctuate with changes in the interest rate and market expectations.  The ASX has got a great education module on investing in general but has a good part about bonds.

As with shares, when choosing an investment you should read the prospectuses and compare

Cost including hidden costs using the Indirect cost ratio

Buy/Sell Spread – How much will you lose when buying and selling due to the difference in prices between the two

Liquidity – How many buyers are there? Will you be able to sell when you need to?

Yield – Is it fixed or floating? How does it compare with other bonds?

Risk – How Creditworthy are the bond issuers?  How confident can you be of getting your initial investment back?

– Property

It appeals to me to have property income to diversify retirement income.

Watching from the sidelines as a resident in 2008, I realized it would be extremely stressful to have the asset pool from which your only income originates (superannuation) to drop by 50%.

It is often advised to have 3-5 years in cash saved in retirement in case of such downturns.  That cash can be offset against an investment mortgage at 3-8%.  This return should maintain it’s purchasing power far better than in a bank account earning 1-3%.

Many property adviser groups encourage going 100% property.  Putting all your eggs in one basket is risky! The biggest issue with well-selected property (to me) seems to be a legislative risk.  It seems the rules of the game can change quickly and dramatically.

The Property Couch is a podcast with tonnes of super valuable content.

– Shares/ Equities

Owning tiny portions of lots of businesses is a great way to build wealth.  Long-term returns have been around 8-9%.  No-one can predict what future returns will be.

Many are scared by the volatility of the stock market.  The value of each share bounces around constantly, with an extensive debate as to the causes of the changes and what will happen next.  50% or more of these predictions tend to be wrong!

Passive Investing

Passive investing has been shown (particularly through Warren Buffet’s famous bet ) to produce superior results most of the time.  Even great stock pickers struggle to compensate for the fees they charge. Giving your cash to an adviser to invest for an “assets under management” or management fee of 1% or more rarely leads to a better return than simply investing cheap and passively.

Index funds or passive ETFs are a great way to start building a diversified portfolio.  Many will continue to use purely these passive investing strategies exclusively.  Others may choose to dabble in individual stocks once they have worked out a strategy they like.

The ASX (Australian Stock exchange) only accounts for ~4% of the world’s equity markets.  Global asset exposure is an important factor in risk reduction and diversification.  Vanguard suggests an allocation between 50-96% global: Australian equities.

PassiveinvestingAustralia suggests basing the percentage of your total net worth to correlate with the percentage of overseas spending.  Stock spot listed their top 10 global funds with details on funds and other factors to consider.

Where to Learn More About Share Investing

The ASX website has a great beginner’s guide to explaining the basics of stocks, bonds, and more.  Passive Investing Australia is an incredible website with detailed articles taking you through all you need to know to start choosing investments.

If you don’t have the time and just want to get started, consider starting investing small amounts in a Robo-adviser.  You can get started in around ten minutes, and it avoids endless procrastination.

Congratulations on reaching the end of this very long post!  Remember, the most important points are to set some goals and timeline (vague is OK if you’re not sure) and START investing.  Good luck!

Disclaimer

Aussie Doc Freedom is not a financial adviser and does not offer any advice.  Information on this website is purely a description of my experiences and learning.  Please check with your independent financial adviser or accountant before making any changes.

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