dollars + sense
2 November 2011
In this issue:
- Building your income
- Covering your bases
- Demystifying risk
- Is my child's inheritance protected from divorce?
Building your income
During your working years you rely on income from your working life to meet day-to-day living expenses and save for future goals. But once you retire you will most likely depend on your savings, and perhaps some income from the government in the form of the age pension. However, the age pension provides only a basic standard of living so the key to living comfortably in retirement is to generate a steady and reliable income stream from a finite pool of investments. Many people assume that cash, bonds and other fixed interest investments are the best source of reliable income, but there are important alternatives. Income from growth assets is also important – like dividends from shares, and rent from investment property. |
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Bonds and Cash
The starting point for any discussion of investment returns is the risk-free return from government bonds. Bonds and term deposits do not offer capital gains if you hold them to maturity but the government guarantees to return your capital in full. This is why they are referred to as risk free.
You can sell bonds before maturity but prices are set by the market and not guaranteed.
Ten-year government bonds currently yield 5.2 per cent. The best available rates for bank term deposits are currently around 6 per cent. Banks also promise to return any capital you invest in term deposits or savings accounts, in full.
If you need to earn a higher return on your money then you need to accept a higher level of risk from corporate bonds, so-called ‘hybrids’, or traditional growth assets such as shares and property.
Bonds are capital guaranteed but they are not entirely risk free. Inflation eats away at the real return on bonds and bank deposits. So if the annual rate of inflation is 3 per cent, the real return on a bond with a 5.2 per cent yield is just 2.2 per cent and the real return on a 6 per cent term deposit is 3 per cent. If your cash is in an everyday transaction account you are actually going backwards.
Shares and property
Dividends and rental income are not guaranteed in the same way as interest from a government bond or bank term deposit, but they do provide a relatively stable income stream. What’s more, the income from growth investments is not fixed but may grow over time as companies lift their dividends and rents increase.
In the year to 30 June 2011 Australian shares rose 7.5 per cent, while dividends added an additional 4.2 per cent return. In fact, the dividend yield from shares has averaged about 4 per cent a year over the past 20 years.
When franking credits are included the dividend yield from the Australian market is around 5 per cent. Some shares, such as bank shares, have a dividend yield of about 6.5 per cent, and more when franking credits are included.
In the 20 year period 1990–2010, residential property delivered total returns of 9.8 per cent a year, similar to shares. Yields on houses are typically around 3 per cent and on units they are a little higher at about 4 per cent.
Generally the longer you hold your investment property or shares, the better the income stream. If you made your investment 20 years ago you could be receiving a yield of 10 per cent of your initial purchase price.
Not only do shares and property provide a healthy income stream, they also offer potential capital gains. The key word here is ‘potential’, because capital gains are not guaranteed. But the longer you hold your investments the closer your returns are likely be to the long-term average.
Over the long run, shares and property produce higher returns than cash or bonds but in the short-term they are more volatile. For example, in the 30 years from 1980 to 2010 Australian shares returned 14.9 per cent a year on average, but this smoothes over some wild swings. In their best year shares rose 67 per cent. In their worst, they fell 39 per cent.
Diversified income streams
A well-diversified investment portfolio should include income streams from a variety of sources and have a range of maturity dates. That way, you will never be stuck for cash if an investment fails or a fund is frozen.
One of the biggest risks facing investors is the risk that their savings won’t last the distance. Today’s 65-year-old retiree can expect to live another 20 years or more, long enough to experience more than one investment cycle. By including shares and property in the mix you not only stand to benefit from a growth in the value of your investments but the income they provide will generally grow over time.
If you would like more information please call the Financial Planning team on 5831 1233.
Covering your bases
Is ‘cheap’ necessarily cheerful?
Television commercials abound which offer quick and easy insurance cover. But how good is the cover they offer?
It could be argued that the cheaper the policy and the less rigorous the application, the greater the chance you will be disappointed should you ever have to make a claim. It’s not that the policy isn’t necessarily good enough in its own right, it’s rather that a generic off-the-shelf policy isn’t tailored to your needs and could easily miss the mark.
For example, a life insurance policy without a medical examination may be simpler but typically it’s also likely to cost more, and deliver less. It makes commercial sense when you think about it. If the insurer does not know your medical history, they need to cover themselves against all eventualities.
And so do you. That’s why you should look at the entire suite of life products (life, total and permanent disability, trauma and income protection), so you know you are properly insured should you be unable to earn an income and provide for your family. After all, your ability to earn is your most important asset.
According to the Financial Services Council’s website Lifewise, a 25 year old male has a lifetime income potential of $4.1 million. If you suddenly find you can’t work, then that’s an awful lot of money to be foregoing. The disability support pension falls well short of the income potential amount, so it’s a sound argument for making sure you have effective and adequate policies in place.
Looking at the whole packageThere is a range of insurers out there advertising different policies, each with different levels of cover, and different exclusions and inclusions.
As a result you need to do your homework and make sure you have the right combination of policies to meet the needs of you and your family.
And that’s where a professional financial adviser comes in. Rather than taking out various policies piecemeal, an adviser can look at your life situation holistically and provide a solution through fully underwritten policies designed specifically to meet your needs. By looking at the whole picture you can also consider the coverage you may have under your superannuation, and what you need to fill in the gaps.
Perhaps now is a good time to talk with us about the right insurance cover for you. Feel free to call our insurance specialist, Clint Thomas on 5831 1233.
Demystifying risk
The term ‘risk tolerance' is at the centre of things when it comes to making investment decisions. But what does the term really mean? Is it possible to pin it down so we understand it better, and understand the role it plays in our investment decisions? Researchers into human behaviour and finance like David R Hunter have taken a closer look.1 One way we can share their insights is to put down a few statements about risk – some might call them ‘myths' – and then look more closely at each statement so we can understand what the research really shows. (2) |
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My risk tolerance is high in the good times. But when the markets drop back, so does my risk tolerance.
In fact, according to Hunter, our risk tolerance does not change; it is our perception of risk that changes. He describes risk perception as the rational process we follow in making an assessment, whereas risk tolerance is more of a personality trait.
We might agree that a Formula One driver like Mark Webber has a high risk tolerance for speed. If he drives at 270 km/hr in the straight but drops back to 90 km/hr to take a bend, does that mean his risk tolerance is higher in the straight than it is on a bend? No, his risk tolerance is constant, but his perception of the amount of risk changes; that’s why he reduces speed.
My risk tolerance determines how I allocate my assets. And ultimately it determines whether I’ll meet my investment objectives.
To sort out the relationship between risk and asset allocation, Hunter says it helps to take a closer look at three components of risk.
Risk required is the first of these. This is a financial characteristic which describes the risk you need to take on to achieve your financial goals.
Risk capacity is also a financial characteristic, describing the flexibility built into a financial plan. Put another way, it’s about the answer to this question: How much downside can you cope with before your plans are off track?
Finally, there is risk tolerance. This personality trait describes the level of risk an investor prefers to take.
Asset allocation depends on all three of these risk components. The task for the investor, with their financial adviser’s guidance, is to find the right balance.
I love bungee jumping and abseiling from skyscrapers; therefore I exhibit a high risk tolerance in my investment decisions.
No, this is not what the research shows, according to Hunter. He says there are four types of risk tolerance – physical, social, ethical and financial. In practice, we all behave consistently within a risk tolerance type (eg. physical), but not across these types.
If you love abseiling on weekends you clearly have a high physical risk tolerance, but you may have quite low investment risk tolerance. Being a Mark Webber doesn’t make you into a daring investor.
When it comes to financial risk tolerance, research shows that it has no sub types. In other words, your risk tolerance is the same for insurance, for investments, and for borrowing.
It is possible to estimate my risk tolerance without working with my financial adviser.
Yes, and no, says Hunter. Yes, because the research shows that an investor’s self-estimate of risk tolerance is often better than an adviser’s estimate – when that is just based on an interview with you. But no, because a well-designed and delivered risk tolerance questionnaire, provided by your financial adviser, should give a better outcome.
As with all questionnaires, it is important to eliminate any bias which can lead to over- or under-estimation of risk tolerance.
Getting that estimate right is important so that each investor is comfortable with their investments at each stage through the normal market cycle.
My risk tolerance is determined by key factors such as my age, my time horizon, and my retirement plans.
Hunter says that while factors like time horizon are relevant to investment advice, they are not relevant to assessing risk tolerance. This is not to play down their importance; it is simply to recognise that they are not ‘in the mix’ when you are assessing risk tolerance.
This means it is important to put aside these issues when looking at your risk tolerance. Once that is sorted out and it is time to move on to specific investment advice, then it is time to consider key factors like age, plans and time horizon.
Knowing your risk tolerance
If you and your adviser have a clear idea of your risk tolerance – or any other factors that affect good decision-making – that gives you a really solid platform for an effective financial plan.
If this article has raised questions in your mind, please give us a call on 5831 1233 and the team will be more than happy to help you.
Is my child's inheritance protected from divorce?
Sometimes although other marriage assets may not be. A recent case points to the manner in which a Family Court splits assets ...
In Lovine & Connor [2011 FamCA 432] the court found that the inheritance the husband had received in a testamentary trust from his father who died in 2000 (a year after he married) was considered a capital asset he had contributed to the relationship with no added contribution by his wife. This contributed to the judge awarding him initially 75% of the marraige assets. However, this was then reduced to 60% because he had better future earning capacity than the wife.
So does a testamentary help? Yes it does. Having the inheritance in a testamentary trust helped the court identify it as a capital asset the husband had contributed and not one that had gone into general funds and been unable to link it back to the husband.
If you have more estate planning questions give our resident expert, Greg Luscombe, a call on 5831 1233.